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Monday, April 5, 2010

New 10-Year Minimum Requirement for Grantor Retained Annuity Trusts

On March 24, 2010, by a vote of 246-178, the U.S. House of Representatives passed H.R. 4849, the Small Business and Infrastructure Jobs Tax Act of 2010.  All Republicans voted against this bill, the stated purpose of which is to provide tax relief and infrastructure incentives to small businesses. As with most government assistance programs, this bill will cost a lot of money. In order to help offset that cost, the bill contains a seemingly innocuous and easily overlooked revenue raising provision aimed squarely at limiting the tax benefits of grantor retained annuity trusts ("GRATs"). These irrevocable term-certain trusts are one of the favorite transfer tax reduction tools used by advanced estate planners, particularly those attorneys servicing the needs of high net worth business owners, key executives, professional practitioners and investors.

If the bill becomes law the following new restrictions will be added to Section 2702 of the Tax Code, effective as of the date of enactment of the legislation: (1) GRATs will be required to have a minimum term of ten years; and (2) annuity payments from a GRAT will not be permitted to decrease during the first ten years of the trust.  As with any GRAT, failure to outlive the term may cause the trust's assets to be includible in the grantor's taxable estate, thereby defeating the transfer tax reduction objective in creating the GRAT. Under current tax law there is no minimum required term for a GRAT; in general, the older the grantor the shorter the term selected for the GRAT.

Final passage of this legislation would effectively eliminate GRATs as a viable estate planning strategy for older age clients who may not outlive the required minimum term of 10 years.  Furthermore, for older age clients this legislation would limit the use of a GRAT as a roll-out strategy for life insurance financing techniques, such as premium financing or split-dollar arrangements.

Assuming the bill becomes law, clients may have a very limited timeframe in which to implement shorter-term GRATs so as to reduce their federal transfer tax bite.

For additional information please contact the blog writer, Keith Codron, toll-free, at (800) 497-0864, or email him at keith@octrustlawyer.com.


Wednesday, March 31, 2010

Too Restrictive Operating Agreement Leads to Loss of Gift Tax Exclusion

A federal district court in Indianapolis recently held that the annual gift tax exclusion did not apply to taxpayers' gifts to their children of membership interests in a family-owned limited liability company. The court found that, based on certain restrictive provisions in the LLC's operating agreement, the membership interests represented "future interests" rather than "present interests" in the entity's assets.

The distinction between a present interest and a future interest lies in whether the donee has an unrestricted and unqualified right to the immediate use, possession and enjoyment of the gifted property, or the income therefrom (i.e., a substantial present economic benefit in the gifted property), or, on the contrary, whether such right is postponed or limited in its effectiveness to some future date or time. Gifts of remainders, reversions, executory interests and similar beneficial rights, whether vested or contingent, the use, possession and enjoyment of which, or the income from which, can only be had at some future date or time, represent gifts of future interests in property.

Under federal law, a taxpayer is entitled to an exemption from gift tax with respect to the first $1 million of taxable gifts made over the course of one's lifetime, computed cumulatively on a calendar year basis. Once the $1 million exemption is fully depleted, the tax rate is a flat 35% of a gift's value. Unlike the federal estate tax, the gift tax is not repealed for 2010 or any other year. In determining the amount of a donor's "taxable gifts" for each calendar year period, the first $13,000 of money or other property given to a donee in that calendar year is excluded, provided that the gift is of a present interest. [The annual exclusion amount is indexed for inflation.] A future interest in money or other property does not qualify for the annual gift tax exclusion under §2503(b) of the Tax Code. As a result, a gift of a future interest is deemed a taxable gift in its entirety and causes a depletion of the donor's $1 million lifetime exemption, in whole or in part, whereas a gift of a present interest is deemed a taxable gift only to the extent that the value of the gift exceeds $13,000 per donee per calendar year.

In the Indiana case, Fisher v. United States [S.D. Indiana, 2010-1 USTC ¶60,588 (3/11/2010)], a married couple transferred minority, non-controlling membership interests in their LLC to each of their 7 children.  The taxpayer-donors retained full management control over the LLC, the principal asset of which was an extremely valuable parcel of undeveloped beachfront land bordering Lake Michigan. When taxpayers filed their gift tax returns they claimed the annual exclusion pertaining to each such transfer. However, upon audit of those returns IRS claimed that the gifts were of future interests and assessed the Fishers a gift tax deficiency in the amount of $625,986! The Fishers paid the deficiency and filed a claim for refund in federal district court, alleging, among other things, that the transferred interests in the LLC were gifts of present interests.

The district court held in favor of IRS, stating that the membership interests received by taxpayers' children constituted a future interest, not a present interest, and that, consequently, no annual exclusion would be allowed.  The court based its decision on the following three factors: (1) the children's membership interests did not confer on them a substantial present economic benefit in the LLC's property because, under the operating agreement, the children's right to receive distributions of capital proceeds, whenever such distributions might occur, was subject to a number of contingencies, all of which were within the exclusive discretion of taxpayers as general managers of the LLC; (2) under the operating agreement there was no indication that an unrestricted right to use, possess or enjoy the LLC's property was in fact transferred to the children, and, in any event, the children's right to use, possess or enjoy beachfront land, without more, did not confer on them a substantial economic benefit in the LLC; and (3) although it was claimed that the Fisher children had the right to unilaterally transfer their membership interests in the LLC, under the operating agreement they could do so only if certain conditions were satisfied (such as the fact that the LLC had a right of first refusal if any purchase offers were made), conditions which effectively prevented the children from transferring their interests for immediate value, even to their own family members.

For further information about this or any other blog on this web site, please contact the writer, Keith Codron, toll-free, at (800) 497-0864, or via email at keith@octrustlawyer.com.


Tuesday, March 23, 2010

The Importance of Proper Vesting on Deeds

A recent Tax Court decision in favor of IRS highlights the critical importance of proper grantee-vesting on deeds and other instruments of transfer, and the potentially dire tax consequences of improper vesting.  The case involved the joint interest of a decedent's predeceased spouse in two parcels of real property, an interest that was held to be includible in decedent's gross estate for federal estate tax purposes. Because the transfer deeds creating the joint interest in each property did not expressly state the manner in which the spouses were to hold title, such interest was treated by the Tax Court as a tenancy by the entirety, which, under applicable state law, cannot be devised under a will.

In 1968, Oscar Goldberg, a resident of New York, acquired from his mother a fractional interest in each of two parcels of real property.

In 1977, Oscar, desiring to hold title to the property jointly with his wife, Judith, executed a deed transferring his fractional interest in each property as follows: "to Oscar Goldberg and Judith Goldberg, as wife" (sic). The property interests remained titled in that manner until after Judith's death.

In 2001, Judith died testate, and her will did not explicity mention either of the properties. Judith's will simply split her estate between Oscar and a family trust.

On December 31, 2001, Oscar, acting as executor of his wife's estate, executed a deed on behalf of the estate purportedly conveying to the family trust his wife's one-half interest in the properties.

In 2004, Oscar died. On the federal estate tax return filed for Oscar, his son, Mitchell, acting as executor, included only half the value of Oscar's interest in the properties as part of Oscar's gross estate, believing that the other half belonged to Oscar's predeceased wife, Judith. IRS, however, claimed that the entire interest in each property, not just half, was includible in Oscar's gross estate for federal estate tax purposes, and determined a deficiency against Oscar's estate in the whopping sum of $384,432.96.  IRS based its position on the fact that Oscar's 1977 transfer deed to himself and his wife had created a tenancy by the entirety between the spouses, such that Oscar automatically became the full owner of the property interests once Judith died, notwithstanding any provision in Judith's will to the contrary. In other words, if, in fact, a tenancy by the entirety existed under N.Y. state law, the property interests were not devisable under Judith's will.

On February 16, 2010, in a memorandum decision entitled, Estate of Oscar Goldberg, deceased, Mitchell D. Goldberg, Executor, v. Commissioner [T.C. Memo 2010-26, 99 T.C.M. 1120], the U.S. Tax Court held that IRS was indeed correct.  The Tax Court looked to the laws of New York governing trusts and estates, and ruled that the wording used in the 1977 transfer deed to vest title in the grantees created a tenancy by the entirety between Oscar and Judith. As a result, upon Judith's death, Oscar, as the surviving spouse, succeeded by operation of law to Judith's half of the property interests, becoming the owner again of his original (full) fractional interest in the properties. The purported transfer of property interests to the family trust by Judith's estate, on 12/31/2001, was null and void because Judith's tenancy-by-the-entirety interests were not subject to devise under her will.  Furthermore, because the 1977 transfer deed, on its face, clearly and unambiguously created a tenancy by the entirety under applicable state law, the Tax Court could not consider extrinsic ("parol") evidence to interpret what, if any, Oscar's intent may have been in wording the deed in the manner that he did.

To learn how the 1977 deed should have been worded in order to avoid this unfortunate result, please contact the writer, Keith Codron, Esq., at (800) 497-0864, or email him at keith@octrustlawyer.com.


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 triggering 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.

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 7, 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.


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