A Unique Opportunity

The new tax law (2010 Tax Relief Act) creates an once-in-a-lifetime planning opportunity that ends at midnight, December 31, 2010.

 

Generally, transfers (greater than $13,000 per year) to generations younger than children are subject to what is known as the generation-skipping transfer tax (GSTT), an onerous tax equal to the maximum gift or estate tax rate.  The purpose of this tax, enacted in the late 1980s, is to prevent wealthy individuals from transferring assets to younger generations for the purpose of avoiding application of the estate tax at every generation.

 

The 2010 Tax Relief Act creates a unique opportunity to make gifts through December 31, 2010 that are not subject to the generation-skipping transfer tax.  This is because, under the new law, the tax rate is zero for any generation skipping transfer made in 2010. Beginning January 1, 2011, the tax rate for these transfers with be 35%.  In two short years the rate goes back to 55%.

 

There are three common scenarios offering planning opportunities.  First, make gifts before December 31, 2010 to Skip Trusts.  These are trusts that you create for grandchildren, great grandchildren or more remote generations.  There will be no generation skipping transfer tax.  The gift tax is 35%, after use of the $1 million lifetime gift exclusion.  This strategy is most effective for large taxable estates.  On the gift tax return, you will want to elect out of automatic Generation Skipping Transfer (GST) allocation rules.  For 2010, you will allocate nothing to the GST Exemption because there is no estate tax.  Use a Trust Protector with the power to add beneficiaries (e.g. children/spouse).

 

The second planning scenario deals with the unique planning opportunities for those who are beneficiaries of trusts that will be subject to GSTT upon distribution from the trust.  Distributions should be made from these trusts before December 31, 2010 because the tax rate is 0%.  After this year, the distribution will be subject to at least a 35% tax rate.  Sometimes, there is concern about beneficiaries getting outright distributions.  Some of these concerns may be alleviated if the trustee invests trust assets in limited partnerships or limited liability companies (LLCs) and then distributes the partnership interests or LLC membership interests.

 

The third planning opportunity deals with clearing any loans made to trusts.  The most common scenario involves Irrevocable Life Insurance Trusts.  Until the passage of the 2010 Tax Relief Act, there was no way to allocate the GSTT exemption, so loans were used.  With the new act, you can now allocate the GSTT exemption on a timely-filed gift tax return.  If you unwind the loans now, you can save the 2010 annual exclusion that would otherwise be lost.

 

I strongly encourage you to take advantage of this rare gift from Congress and consider making transfers to generations younger than children, even if you do not yet have grandchildren.  We can help you structure these gifts so that they meet your goals and objectives, regardless of amount.

Qualified Disclaimers

Whether in the context of gift and estate tax planning or probate and trust administration, we have been talking with our clients about qualified disclaimers more than ever.  It is an effective planning technique, but it must be implemented carefully.  The biggest hurdle is that the person making the disclaimer cannot take any benefit from the property to be disclaimed.

 

Estates & Trusts is one of the leading magazines in this area.  The following is a recent article on qualified disclaimers:

 

Qualified Disclaimers in 2010

Use this simple and unique solution to add flexibility in dealing with estate tax uncertainty

By Joe Luby, founder and manager of Jagen Investments, LLC in Henderson, Nev.

What a remarkable time to be in the business of advising wealthy families on financial, tax and estate issues!  It’s remarkable both in terms of the changes and significant developments in the field, as well as for the opportunity afforded us as advisors to set ourselves apart and proactively solve client concerns.  Many practitioners are hamstrung this year with indecision, worry and fear about what may or may not happen with income taxes, estate tax, generation-skipping transfer (GST) tax, etc.  It’s unfortunate for their clients because we’re situated in the perfect tsunami of wealth transfer opportunities.  Asset values are way down, tax rates are the lowest they’re going to be in most of our lifetimes and interest rates are near zero.  Wealth transfer strategies should be on the top of advisors’ minds right now.

As of this writing, it doesn’t look like Congress will act anytime soon on estate tax reform legislation.  Common expectations in the industry expect Congress to eventually enact some version of the law we had in 2009, perhaps with some minor variations.  No one knows for sure, but that seems to be the consensus lately.  One fear commonly expressed by practitioners nationwide is that Congress could try to enact retroactive legislation and thereby disrupt any transactions put in place today.  For example, if they retroactively raised the gift tax to 45 percent or 55 percent from the current 35 percent, then gifts made today become more expensive.  The same fear applies to a retroactive GST tax, which could create a double whammy for gifts made in 2010.

Simple Solution

There’s a simple but unique solution to these concerns: the qualified disclaimer (QD).  In short, to be a QD under Internal Revenue Code Section 2518(b), the QD must:

 

• be in writing; and
• be made within nine months of the date of gift or the date the recipient reaches age 21, whichever is later.

 

Additionally, the recipient may not have accepted the gift, used the gifted asset(s) or benefited from them.  The recipient may not direct where the gifted asset(s) goes upon receipt of the QD (that is, the gift either reverts back to the giver or to the next designated beneficiary, if applicable).

Most of us think of QDs for post-mortem planning opportunities.  For example, the primary beneficiary of a retirement account may use a QD to redirect the funds to the contingent beneficiary for a variety of reasons.  Or, a surviving spouse may use a QD for all or some of the assets in a disclaimer trust,” which specifically incorporates the QD as part of the upfront planning.

In 2010, clients can use QD planning for lifetime gifts to add flexibility and a solution to the issues described above.  Taxable gifts made between now and Dec. 31 are subject to the current gift tax rate of 35 percent under 2010 law.  If we wait to see whether Congress acts retroactively with an increased gift tax rate or GST tax, we will wait ourselves and clients right into 2011 when we know the rate is scheduled to go up.  The time to act is NOW.  Clients can use the QD procedure to undo the gift later, should Congress enact a retroactive tax increase.

Example

Take the following example: Tom Clark would like to gift $2 million of marketable securities to his son Bill.  He establishes a trust naming Bill as primary beneficiary and his wife, Mary Clark as contingent.  The trust is drafted to qualify as a completed gift for tax purposes, and Tom funds the trust with the $2 million securities portfolio.  The family now has nine months (assuming Bill is age 21 or older) to decide if they want the gift to stand.  Should Congress enact a retroactive increase in the gift tax, Bill will simply disclaim his interest in the trust, which then flows to Mary as contingent beneficiary.  The entire transaction is gift tax-free if this option is triggered since the gift is now between spouses.  And if the gift tax rate isn’t increased retroactively, the Clarks have locked in the lower gift tax rate by completing the transaction in 2010.

The same set of circumstances applies to gifts made to grandchildren in the event a retroactive GST is enacted.  Grandparents can use this opportunity to shift significant wealth using the reduced gift tax rate in effect for 2010 and no GST tax, while still retaining flexibility in their planning if necessary to undo the gift.

Additional opportunities are present when using QD planning this year as well.  Assume Congress doesn’t act retroactively and thus the current 2010 gift tax rate of 35 percent applies.  However, Tom’s $2 million portfolio suffers significant losses and drops significantly.  The QD option allows the family to reconsider whether paying the gift tax on $2 million (even at the lower rate in 2010) is really the best strategy.  It may make sense to undo the gift via QD and structure a new gift of the now devalued assets, even though the nominal tax rate may be higher in 2011.  If the assets are depressed in value already due to market turmoil over the last few years, the reverse may apply.  If the $2 million portfolio recovers significantly in value, the family wins by having locked in the gift now in 2010 at the lower value and reduced gift tax rate.

Discounted Value Assets

Lastly, any gifting strategy using QDs can be greatly enhanced with the use of discounted value assets.  The net after-tax impact of the gifting strategies described above is even higher when the asset gifted is subject to valuation adjustments.  Examples of such assets are fractional real estate interests, closely held business interests and private investment funds. For example, an asset subject to a 30 percent discount results in a net effective federal gift tax rate on the full asset value of less than 25 percent.  So not only can the client lock in 2010’s lower gift tax rate with the flexibility to undo the transaction later, but also he can even reduce the effective rate via proper advanced planning.

 

Nonprofits Must File by Oct. 15 to Maintain Status

Small tax-exempt, nonprofit groups are now required to file a tax form with IRS, or risk losing their tax-exempt status. Many should have filed in May, but the IRS has granted a one-time relief program that extended the filing deadline to Oct. 15.

Congress passed legislation in 2006 that requires all tax-exempt organizations, except churches and religious organizations, to file an informational 990-N return annually with the IRS starting in 2007. Before that legislation, organizations that collected $25,000 or less in a year were not required to file. For the first time those that didn’t file for three consecutive years are at risk of losing their tax-exempt status. That three-year window hit in 2010.

Even though the IRS sent out one million letters to inform these groups of the new regulation, many still didn’t file and are in jeopardy. Wisconsin has an estimated 6,000 small, tax-exempt organizations affected by this legislation. Close to 1,000 organizations In Milwaukee are on the list.

The form is short and takes just a few minutes to fill out. It contains eight questions, such as the employer identification number, name of organization, address, principal officer, etc. It can be found on the IRS website and can be filled out electronically.

Requiring this has given the IRS a means of creating an accurate, updated list of charitable organizations so people can determine whether an organization is tax-exempt and their contribution is deductible.

A Burning Issue . . .

“The fault of most men is not that they aim too high and miss, but that they aim too low and hit.”   – Michelangelo

An article in the Sunday edition of the Milwaukee Journal Sentinel addressed an issue that is particularly relevant in our area. For some time it has been fairly common for owners of tear-downs to make a charitable contribution of the house to their local fire departments for a tax deduction. The fire department burns it down for practice. Lately that strategy has been under attack by IRS.

This is something that has been done for a long time, but IRS is looking at it differently now. For years, IRS allowed deductions for homes donated to fire departments, based on a 1973 court opinion interpreting the IRS code written in 1968. But the tax code changed in 1969 to specify that donating anything less than the entire interest in a property, such as its use, is not deductible as a charitable contribution. Around 2004, IRS started disallowing deductions for homes donated for fires.

The heart of the issue is the value of the house. Usually when you give to charity, you can deduct the fair market value of the property that is gifted. In this case, what is the value of something that is going to be destroyed anyway?

This article tells the story of a Chenequa couple that bought an old house on Pine Lake in 1996. In 1998, they let the Chenequa Fire Department burn it down and claimed a charitable deduction of $76,000. Replacement value was about $235,000. IRS disallowed the deduction, saying that because the home was going to be torn down anyway, it had negative value, or was worth approximately $1,000 if someone was willing to move it. The owner decided to fight the case. It was argued before a tax judge in 2005, but they’re still waiting for a decision.

If the U.S. Tax Court agrees with IRS, the decision will likely end the symbiotic relationship between owners of tear-downs and their local fire departments.