In his recently released budget proposals, President Obama included may familiar challenges to advanced estate planning techniques as well as some new wrinkles designed to thwart creative planning for high net worth individuals and families. Here is a brief summary of those proposed changes:
- Restore 2009 Estate and Gift Tax Exemptions and Rates – The current estate, GST, and gift tax rate is 40%. Each individual enjoys a lifetime exclusion for all three types of taxes of $5,340,000 in 2014, indexed for inflation. Beginning in 2018, the President proposes making permanent the exclusions and rates in effect in 2009. Therefore, the top tax rate would be 45%, the estate and GST exclusion amount would be $3.5 million and gift tax exclusion amount would be $1 million. These amounts would not be indexed for inflation. So much for permanent estate tax law changes.
- Require consistency in value for transfer and income tax purposes – Under current law, it is possible for taxpayers to take inconsistent positions in dealing with the Internal Revenue Service when determining the basis of property acquired from a decedent. The President’s proposals would require both consistency and new reporting requirements.
- Require minimum term for grantor retained annuity trusts (GRATs) – Taxpayers currently can enjoy significant estate planning benefits by using short-term GRATs. Under the Walton case, the Tax Court (and ultimately the IRS) approved the use of a two-year GRAT. Similar to prior proposals, the President proposes that a GRAT have a minimum term of 10 years and a maximum term equal to the life expectancy of the annuitant plus 10 years. While this will not prevent “zeroing out” of GRATs, it will increase the risk of estate tax inclusion if the grantor fails to outlive the GRAT term.
- Limit duration of GST tax exemption – Because of the proliferation of dynasty trusts due to recent favorable changes in state laws, many taxpayers have been able to shift enormous amounts of wealth into these trusts without having distributions from the trusts being taxed to heirs that may be three or more generations removed from the donor. The President’s proposal generally would cause the GST exclusion available to such trusts to expire on the 90th anniversary of the creation of the trust. Importantly, this proposal would apply to trusts created after enactment of any legislation and to the portion of a pre-existing trust attributable to additions to the trust made after that date.
- Eliminate the use of intentionally defective grantor trusts – Under current law, a taxpayer may sell or transfer an ownership interest in property or an entity to an intentionally defective grantor trust that is effectively ignored for income tax purposes but recognized as a separate entity for estate and gift tax purposes. This technique has permitted high net worth taxpayers to shift enormous amounts of wealth to future generations at little or no tax cost. Under the President’s proposal, if a person who is deemed an owner under the grantor trust rules of all or a portion of the trust engages in a transaction with that trust that constitutes a sale, exchange or similar transaction that is disregarded for income tax purposes (i.e., because the trust is treated as a grantor trust), then the portion of the trust attributable to the property received by the trust in that transaction will be subject to estate tax and included in the gross estate of the transferor, will be subject to gift tax at any time during the deemed owner’s life when his or her treatment as a deemed owner of the trust is terminated, and will be treated as a gift by the deemed owner to the extent any distribution is made to another person during the life of the deemed owner. In effect, the President proposes eliminating the use of intentionally defective grantor trusts to effectively shift wealth out of an estate at little or no transfer tax cost. The proposal would reduce the amount subject to transfer tax by any portion of the amount that was treated as a prior taxable gift by the deemed owner any transfer tax imposed under this proposal would be paid from the trust.
- Simplify annual gift tax exclusion rules – The first $14,000 of gifts made to each donee in 2014 is excluded from the donors taxable gifts and does not use any portion of the donor doors applicable exclusion amount for estate or gift tax purposes. The ability to use the annual exclusion requires that the gift be of a present interest. Many donor doors contribute property to a trust and give each trust beneficiary a power to withdraw the contribution on a temporary basis. This so-called Crummey power (named for a famous 1969 court case) converts and otherwise future interest into a present interest. The President proposes eliminating present interest requirements for gifts that qualify for the annual gift tax exclusion. Instead, there would be a new category of transfers (without regard to the existence of Crummey powers) that would be subject to an annual limitation of $50,000 per donor. The new category of transfers would include transfers in trust, transfers of interests in S corporations, family limited partnerships and LLCs, and certain other transfers. Transfers in excess of $50,000 would be subject to tax or would offset the applicable exclusion amount.
- Extend the state tax lien imposed under section 6166 – If an estate qualifies for deferral of estate tax on certain closely held business interests, the maximum lien imposed under the Internal Revenue Code currently is 10 years. The President proposes extending the lien for the entire 6166 deferral period, which may be as long as 15 years and three months following the date of death.
- Modify GST tax treatment of HEETs – Donors currently can pay the costs of medical care directly to medical care providers and the cost of tuition directly to schools without being subject to gift tax were being used against the annual exclusion or lifetime exemption from gift tax. A comparable exemption applies under the GST tax for similar gifts. Arguably, the language of the GST statute permits the avoidance of GST tax through trusts known as “health and education exclusion trusts” or HEETs, which provide for the payment of medical expenses and tuition for multiple generations of descendants. The President’s proposal effectively would eliminate the use of HEETs by allowing the GST tax exclusion to apply only to a payment by a donor nor directly to the medical care provider or to the educational institution and not to trust distributions.
- Expand definition of executor – Under current law, the narrow definition of “executor” in the tax code limits the ability of an individual to act on behalf of of a decedent with regard to a tax liability arising prior to the decedent’s death. In other words, no one has the authority to extend the statute of limitations, claim a refund, agree to a compromise or assessment, or pursue judicial relief in connection with a decedent’s share of the tax liability. The President proposes expanding the definition of executor for all tax purposes so the executor can do anything on behalf of the decedent in connection with the decedent’s pre-death tax liabilities or obligations.