President-Elect Obama Estate Tax Reform- Thoughts on what might happen

As 2009 has been approaching there has been much anticipation as to what Congress and the President might do with the estate tax.  Currently, each individual can pass $2,000,000 free of estate tax to his or her heirs.  In 2009, this amount will increase to $3,500,000.  In 2010, the estate of a decedent will not pay any estate tax (the exclusion is unlimited) but the heirs of the decedent in 2010 will not receive all of the assets of the decedent with a basis adjustment (the so-called step up in basis). Under current law no income tax is paid by the heir inheriting the decedent’s assets because of this basis adjustment. In 2010, however, the heir will have to use the basis of the decedent (with some exceptions) which means the heir will have to pay tax on the gain when the inherited asset is sold as the decedent would have to do.

In 2011 the estate tax exclusion amount is reduced to $1,000,000 per person and is set to stay at this level indefinitely.  (Note: As an aside, remember an individual can pass to a spouse an unlimited amount estate tax free (the so-called marital deduction) and an unlimited amount to a charity  (the so called charitable deduction))  During the recent election campaign (and prior to the economic freefall of the U.S. economy) President-elect Obama indicated he would support extending the exclusion of $3,500,000 indefinitely and keeping the current estate tax rate of 45%  for the value of the estate above the exclusion amount.  With the economic forecast looking dismal for the foreseeable future, will President-elect Obama and the Democratic controlled Congress accept the 2009 exemption amount of $3,500,000 or not?

Remember, during the campaign for President, then Senator Obama indicated anyone earning over $250,000 was wealthy and would likely see the taxes on their income increased under his administration if he had his say.  Is $3,500,000 wealthy?  Is a millionaire wealthy? I suppose it depends on your perspective. According to the Wealth Report by Robert Frank, as reported in the Wall Street Journal on November 22, 2008 Merrill Lynch reported there were 3,000,000 millionaires (individuals with a net worth of $1,000,000, excluding their personal residence) in 2007. If you count the residences of millionaires in the calculation of who is a millionaire there were 9,000,000 of them in 2004 according to Federal Reserve data.  As I have found in my practice there are a significant number of millionaire to be found everywhere.  Planning for millionaires is quite common place.

With a national debt of roughly 10.6 trillion (for the most current number go here) one can only expect the estate tax might just be on the agenda of a President and a Democratically controlled Congress notwithstanding the campaign rhetoric and promises.  So, what might we come to expect in 2009 in the way of estate tax changes.  I have my short list of what I think we might see.  We will no doubt know a whole lot more by the end of 2009.

First, I think Congress will act and the President will sign a bill which extends the estate tax exclusion of no more than $3,500,000. It could be less, but I cannot imagine below $2,000,000.  I believe the rate will be 45% for all taxable estates above the exclusion amount.

Next, I don’t believe they will eliminate charitable or marital deductions, but will try to make the marital deduction “portable.”   This means upon the death of the first of a married couple to die the surviving spouse will inherit so to speak all or a portion of the first to dies exclusion amount, which is not used by the first to die.  For example, if the first to die had a taxable estate of $1,000,000, which was distributed to someone other than the surviving spouse and some of the exclusion was used to avoid paying any estate tax, the surviving spouse would receive an additional $2,500,000 of the exclusion (not used by the spouse first to die), which can be used by the second to die.

This will avoid having to undertake some of the the sophisticated planning currently required to be used by the modest millionaires to insure both souse’s exclusions are used.  If such a change occurs there will be a need to file an estate tax upon the death of the first spouse (although it may be an abbreviated one).  There will also need to be a provision to avoid marrying just to get the exclusion of the first to die.  Sounds a bit grizzly, but you can see this happening as there is significant amount of money at stake.  Imagine Sue surviving Sam and marrying three more husband.  Would she get to have potentially four exclusions plus her own for a total of $17,500,000.  The devil will be in the details.

Next, we are likely to see an attack on discounts afforded estates of owners of family entities who create entities for reasons other than non-tax reasons just to get discounts on the value of the interest they own in their family entity.  The discount of the value of the interest owned at the time of death of the owner of an interest in the family entity currently enables the decedent’s estate to avoid having to pay as much in estate tax.  This “discount planning” has been on the IRS radar screen for some time and might just be eliminated during the upcoming Congressional session.

2009 will be an exciting year for planning for taxable estates.  Even with the recent economic downturn there will still be plenty of taxable estates and plenty of estate tax planning.  Many clients have been on the fence and avoiding any estate tax planning, not knowing if they should plan or not, while they waited for the estate tax to be possibly eliminated.  Although eliminating the estate tax was high on the agenda of the Bush administration the efforts were thwarted by the Democrats as the Republicans never could muster the 60 votes in the Senate to permanently repeal the estate tax.  Now that the Democrats are in control of Congress (and the prospects of the Republicans who support repeal of the estate tax being in control of Congress in the forseeable future being a long shot if not impossible for decades to come) elimination of the estate tax is certainly a non-starter and most will be lucky if the $3,500,000 exclusion continues.

Stay tuned.  The ride should be an interesting one.  The new reform will be a boom to estate planners as they continue to explore ways to leverage the exclusion Congress does let everyone keep.  Estate tax planning helped me get my children through college and now will help me help my grandchild (and maybe grandchildren) get through as well.

Reflections on this last week

What a crazy week it was.  Perhaps it was too much turkey.  Maybe it is the end of the year and the holiday frenzy or blues.  I don’t know, but clients seem to be exhibiting behaviors which are at times predictable and at other times buying into the frenzy.

Mrs. X who first visited my office about two months ago called in a panic.  She and her husband had moved to Grand Junction about 8-10 years ago.  We visited about updating their estate plan to conform to Colorado law as well the changes in their life involving their heirs.  One child had died.  Two others were suffering from disability and they did not feel they could leave their estate to them outright for fear their current governmental benefits would be terminated.  Yes, they did need to make some changes. 

Our office gets the call from Mrs. X on Thursday (60 plus days after we talked about needing to update their documents) in a frenzy.  Her husband was having surgery the following Tuesday and could I please draft a financial power of attorney for them to come in and sign today.  Their crisis was now my crisis.  I was able to move other client priorties to help them and they plan to come by the office on Monday (Mr. X won’t be able to get out of the car and actually come in to the office due to his health condition) to sign the document.  I don’t understand the thinking about being proactive in your estate plan.  None of us like to talk about yet alone dwell on our own mortality, but we do like to be prepared.  We do like to have our ducks in order.  I have pleaded with clients over the years to stay on top of their planning and don’t procrastinate, but I am getting hoarse.

Other clients are quite concerned about the economy. In one estate we negotiated a deed in lieu of foreclosure (in effect selling the property back to the bank) for an estate which owned property out of state.  The banks are really in an upheaval and trying to get them to respond is very very difficult.  Many clients are in a panic.  For some the down turn has presented real problems with their retirement planning, cash flow, etc.  Legal services are said to be discretionary spending and I believe this to be the case.  Many clients are planning just to get them by, hoping in the future, they can do the planning they really want to do.

Other clients, such as a couple I visited with this last week, are looking at the depressed values as a planning opportunity to transfer assets to their heirs.  They are considering gifting of assets at reduced values.  The lower values combined with lower interest rates provide real planning opportunities which may not be seen for some time in the future.  Freezing the estate values (currently low) and gifting or selling the assets to your heirs can be a great technique to maximize the amount you can pass to your children.  Some of the techniques being considered by clients include self-cancelling notes, sales to intentionally defective trusts and grantor retained annuity trusts.  Although sophisticated and complex the results can be very rewarding.

And last but not least there is the family who cannot understand why a sibling and daughter would have left a handwritten will (yes, those are legal in Colorado) leaving her estate to an ex-boyfriend instead of to her family.  Apparently, she had broken up with the boyfriend some 10 years ago, but never changed the handwritten will. Leaving an old will lying around without changing or revoking it can have unintended consequences.  Although the family claims there was a later will it has dissappeared. Hmmm.  Something smells kind of fishy, but there just is not much which can be done.

All in all a pretty exciting week, with a lot of activity.  Most is predictable, but a lot is not. With only 3 1/2 weeks to go until the end of the year, the pace seems to be picking up.  With a new Congress seeking ways to give out money (and hopefully finding ways to pay for it) one can expect lots of exciting law changes this next year to be watching.  Many of them will impact the readers of this blog.

President-Elect Obama–Now what?

Now that Barrack Obama has been elected President of the United States and the Democrats in the Senate are close to having the 60 votes it needs to close off any attempt at a filibuster, what might we expect in 2009? If we assume the campaign rhetoric to be anywhere close to reality there are a few projections we can now make.

1. Highly likely. The all important estate tax exclusion is to increase under current law to $3,500,000 for decedents dying in 2009. President-elect Obama has said he supports an extension of this amount and no more beyond 2009. It would not be far fetched to expect Congress to act on the extension of this amount in 2009.

2. Highly likely. President-elect Obama has also indicated he would like to keep the estate tax rate at 45%. This means an individual with an estate of $4,500,000 (assuming he or she does not have a spouse) would have an estate tax of $450,000 (45% of the $1,000,000 over the exclusion).

3. Probable. It is likely Congress will keep the basis adjustment of assets which pass from a decedent’s estate. Now, when a person dies owning a $100,000 assets, which cost him or her, $20,000 (their basis), the heirs receive the asset along with a new date of death basis of $100,000. This means when the heir sells the asset there is no capital gain. Had the decedent sold the asset when he or she was still living the decedent would have had to of paid the capital gains tax on the $80,000 gain.

Under current law the basis adjustment would have gone away for decedents dying in 2010 (although subject to some exclusion amounts) and instead the heirs would have had to pay tax on the gain when they sold the inherited asset just like the decedent would have. It is likely Congress will change this to avoid the 2010 carry over basis regime coming into play in 2010. This is huge from an accounting perspective.

4. Probable. Planning now for a couple with a taxable estate (an estate of over $3,500,000 starting in 2009) usually requires the creation of a trust when the first spouse dies. This trust is commonly referred to as a bypass or credit shelter trust and the assets which pass into this trust when the first spouse dies are not included in the estate of the second spouse to die and therefore pass to the heirs of the couple estate tax free. It is likely in 2009 Congress (which is supported by President-elect Obama) will allow the exclusion amount to be “portable.” This means when the first spouse dies the surviving spouse will have a $7,000,000 exclusion amount to use when he or she dies.

Portability of the exclusion will allow the assets to pass to the surviving spouse without the need to set up a bypass trust when the first spouse dies. The exclusion is portable (or transferable) from the first to die to the survivor. The surviving spouse will be able to access the entirety of the couples resources without the need to utilize a bypass trust.

Since 2001 couple clients of our office have overwhelming been using a type of estate plan which incorporates a “disclaimer” estate plan. This plan allows the surviving spouse to accept all of the assets of the first to spouse to die and disclaim only as much as is necessary to insure the surviving spouse does not have assets in his or her estate more than necessary to avoid paying an estate tax. An example, would be a couple with a $5,000,000 estate, divided equally between the husband and spouse. When the first spouse dies with a disclaimer plan in place the survivor would likely “disclaim” $1,500,000, allowing the amount to pass into the bypass trust. The surviving spouse could still use the assets in the bypass trust, but on a limited basis.

It would not be necessary under the concept of portability to create the disclaimer trust. Such an estate plan would likely still work under the concept of portability, without any need to change an existing estate plan for this reason alone.. All assets would pass to the surviving spouse who would then be able to use a $7,000,000 exclusion.

The crystal ball is still a bit murky, but it will likely clear very quickly in 2009. As details of any Democratic plan come forth we will keep you posted.

Note:  This post is actually an earlier post (late in the evening of November 4, 2008) which was moved to this blog.

The Qualified Personal Residence Trust- Now may be the time to give it a try.

With residential real estate values falling (and hopefully near the bottom) now may be the time to consider transfering the residence to your heirs and leveraging the transfer by utilizing a Qualified Personal Residence Trust (QPRT).  These trusts are used by high new worth individuals with a likely taxable estate. Let me explain how a QPRT might help you by giving you a case study.

Case Study: Taxable estate containing a residence (or a vacation home) The Situation and Goal of Sam An individual, Sam, age 60, has what is likely to be a taxable estate. Sam has an estate of $4,500,000, which includes a residence valued at $1,000,000. The residence will likely increase significantly in value prior to his death. Recognizing the possibility Congress will not change the current estate tax law (which will impose an estate tax on estates in excess of $1,000,000 for those individuals dying in 2011 and beyond), Sam wishes to be proactive and look at ways to reduce the estate tax which may be owed upon his death.

A possible solution Sam has heard of is a trust, a “Qualified Personal Residence Trust,” (QPRT) which may meet his goals. He has heard he can transfer his residence to the trust, thereby capping the appreciation of the residence. By capping the increase in the value of the residence, he can also reduce the amount of estate tax his estate may have to pay. The use of the QPRT may have a substantial impact on the value of assets which can be passed to an individual’s heirs.

For decedents dying in 2008, the amount which can be sheltered from estate tax is $2,000,000 (the “applicable exclusion amount”). The applicable exclusion amount increases to $3,500,000 for those dying in 2009 and is unlimited for those dying in 2010 (although there is a new complicated tax created in 2010 by a change in the way heirs must pay a tax when the inherited property is sold, having to use in part the old cost basis which is a version of an old “carryover basis” taxing concept). In 2011, the applicable exclusion amount returns to $1,000,000, which is based on earlier estate tax law. Any estate tax in 2011, under the current laws, would be taxed starting at 41% and rising from there. There are a multitude of ways of planning to reduce the impact of the estate tax. The planning techniques generally fall into one of five categories: (1) giving away assets, thereby removing the future appreciation of the assets from the individual’s estate; (2) making the assets worth less on paper through the use of family entities having a business purpose; (3) making charitable gifts; (4) using life insurance to pay the cost of the anticipated estate taxes; and (5) for some, who are owners of a closely held business or are farmers and ranchers, there are other special provisions.

Using a QPRT is a planning technique involving a residence or vacation home which combines giving away assets and making them worth less on paper. This effective planning technique may be advantageous, depending upon the current value of the individual’s estate, the anticipated growth of the value of his or her estate, the individual’s anticipated life expectancy, and the desire to maximize the amount which can be passed free of estate tax.

To utilize a QPRT, a residence or vacation property is transferred into a trust. Each individual is allowed to establish only two QPRTs: one for his or her residence and one for his or her vacation home. The creator of the trust, the grantor, reserves the right to live in the residence (or the vacation home) for a set number of years, after which the residence would pass to the remainder (or future) trust beneficiaries. For example, if an individual (the grantor) transfers his or her residence into a trust but yet reserves the right to live in it for the next twenty years, at the end of the twenty-year term the value of the residence, together with any appreciation between now and the end of the twenty-year term, would pass to the remainder beneficiaries.

Assuming the grantor (creator) of the trust survives the chosen term of the trust, the value of the residence would not be included in the grantor’s estate upon his or her death and would not be subject to estate tax. Upon the creation of the QPRT, the grantor would value the future interest to be transferred to the remainder beneficiaries. To avoid paying a current gift tax, the grantor will likely elect to utilize a portion of his or her “gift tax lifetime exclusion” which is currently $1,000,000. To the extent a portion of an individual’s gift tax lifetime exclusion is used during life, the amount so used will be deducted from his or her applicable exclusion amount available at death (currently $2,000,000).

As an example, if an individual created a QPRT and the value of the gift to the remainder beneficiary was $350,000, his or her applicable exclusion amount would be reduced by the $350,000. If the applicable exclusion amount was $2,000,000 at the death of the individual, he or she would have $1,650,000 of his or her applicable exclusion amount left. In the above example, if the grantor were to die before the expiration of the twenty-year period, the full value of the residence at the time of death would be included in the grantor’s estate. Any portion of the individual’s applicable exclusion amount which had been used by the prior gift, however, would be “restored.” Additionally, the individual’s estate would receive a credit for any gift taxes which had been paid.

The longer the time period an individual chooses to retain the right to live in the residence subject to the QPRT, the less the current value of the gift to the heirs. One might say, “Pick a long time period to lessen the value of the current gift and the use of the gift tax lifetime exemption.” There is some logic to this, but remember, if the grantor dies during the selected term, the full value of the residence (i.e. value at the time of the grantor’s death) is included in the grantor’s estate. It is important to individuals creating QPRTs to pick realistic time periods they believe they can survive. The longer the time period chosen, the smaller the value of the gift to the remainder beneficiaries. The smaller the value of the gift to the remainder beneficiaries, the smaller amount of the applicable exclusion amount which would be used.

Using a QPRT can be a very effective way of shifting what would potentially be a high value asset in an estate into the names of the grantor’s heirs. Let’s look at some numbers to help understand the benefits of a QPRT. Sam’s residence has a current value of $1,000,000 and is expected to increase in value at 5% per year. Using a twenty-year term for the QPRT, the residence will have increased to a value of $2,653,298 at the end of the twenty-year term. At the time the QPRT is created, the present value of the interest to the remainder beneficiaries is based on the age of the grantor (Sam’s age is 60); the then stated IRS “7520 rate;” the value of the residence; and the term of the trust. In Sam’s case, the value of the gift to the remainder beneficiaries is $171,630. Yes, it is true! The current gift is only $171,630! If Sam is able to outlive the chosen term, he has effectively removed $2,481,668 from his estate. At an estate tax rate of 45%, this would be a savings to his heirs of $1,116,750!

Using the QPRT allows individuals to transfer great wealth at a low transfer tax cost. The QPRT trust is not right for everyone but is certainly right for others, regardless of the actions taken by Congress over the next few years. The QPRT may be right for those who fit the following criteria: Individuals with a high net worth who believe they will have a taxable estate regardless of what Congress does with estate tax reform (other than eliminating it). It is possible Congress would allow the estate tax exclusion to remain at $1,000,000 starting in 2011 (which is not believed to be likely). President-elect Obama has indicated he favors a $3,500,000 exclusion with a tax rate of 45% on the value of all assets in excess of this amount.  The exclusion amount would be twice this amount for a couple.

If the value of an individual’s estate, including a residence, is in excess of this amount (allowing for an inflation adjustment), then a QPRT may be a viable option.

It is important to remember, however, the power of inflation and how it erodes the effectiveness of the applicable exclusion amounts. Those who anticipate keeping their residence or vacation home for the balance of their lives, who are in good health (as it is important the grantor of the trust outlive the selected term of the QPRT) may find the use of the QPRT a perfect fit for them. 

A QPRT may not be right for everyone. If you have bad health and cannot survive the selected retained term of years; anticipate selling your residence to fund other cash flow needs; believe your estate will escape estate taxes; don’t want to pay rent to your remainder beneficiaries if you want to continue to reside in the residence at the expiration of the retained term of years; have a mortgage against the residence intended to be transferred to the QPRT; or fear loss of flexibility or control of the residence, the QPRT may not fit your needs.

There are additional considerations to the use of a QPRT. When the grantor makes a gift, a gift tax return will have to be prepared and filed with the IRS (between January 1 and April 15 of the year after the calendar year in which the gift is made). Appraisals will also have to be obtained (appraising the residence to be transferred to the QPRT). The costs associated with filing the gift tax return and securing the appraisal will need to be taken into account. It may also be possible for grantors to leverage their current gifts if the interest they own in the residence is co-owned with another individual such as a spouse. Obtaining a further appraisal, which would value each of the co-owner’s fractional interest in the residence, would result in a lower value of the gifted interest. This additional appraisal would “discount” the value of the asset based on the lack of marketability and control of the owner of the fractional interest. Discounts can further reduce the pro rata or liquidation value of the grantor’s interest by as much as 5% to 40%, or even higher depending upon the circumstances. If a grantor wishes to discount the value by obtaining yet another “discount appraisal,” this appraisal will need to be included with the gift tax return explaining the valuation and the discount taken.

It is necessary to have an “expert” prepare this discount appraisal. There are many nuances to a plan for any particular individual. Whether the QPRT is a “tool” which fits into your planning depends upon a variety of factors. It is best to analyze these in the context of the individual’s overall estate plan, balancing the plan with his or her long-term goals to ensure there is a match. Creating a QPRT does take time to accomplish and is not a simple form which can be created using modern-day technology. Each must be crafted in such a way as to meet the individual’s goals.

The votes are in!! Now what?

Now that Barrack Obama has been elected President of the United States and the Democrats in the Senate are close to having the 60 votes it needs to close off any attempt at a filibuster, what might we expect in 2009? If we assume the campaign rhetoric to be anywhere close to reality there are a few projections we can now make.

1. Highly likely. The all important estate tax exclusion is to increase under current law to $3,500,000 for decedents dying in 2009. President-elect Obama has said he supports an extension of this amount and no more beyond 2009. It would not be far fetched to expect Congress to act on the extension of this amount in 2009.

2. Highly likely. President-elect Obama has also indicated he would like to keep the estate tax rate at 45%. This means an individual with an estate of $4,500,000 (assuming he or she does not have a spouse) would have an estate tax of $450,000 (45% of the $1,000,000 over the exclusion).

3. Probable. It is likely Congress will keep the basis adjustment of assets which pass from a decedent’s estate. Now, when a person dies owning a $100,000 assets, which cost him or her, $20,000 (their basis), the heirs receive the asset along with a new date of death basis of $100,000. This means when the heir sells the asset there is no capital gain. Had the decedent sold the asset when he or she was still living the decedent would have had to of paid the capital gains tax on the $80,000 gain.

Under current law the basis adjustment would have gone away for decedents dying in 2010 (although subject to some exclusion amounts) and instead the heirs would have had to pay tax on the gain when they sold the inherited asset just like the decedent would have. It is likely Congress will change this to avoid the 2010 carry over basis regime coming into play in 2010. This is huge from an accounting perspective.

4. Probable. Planning now for a couple with a taxable estate (an estate of over $3,500,000 starting in 2009) usually requires the creation of a trust when the first spouse dies. This trust is commonly referred to as a bypass or credit shelter trust and the assets which pass into this trust when the first spouse dies are not included in the estate of the second spouse to die and therefore pass to the heirs of the couple estate tax free. It is likely in 2009 Congress (which is supported by President-elect Obama) will allow the exclusion amount to be “portable.” This means when the first spouse dies the surviving spouse will have a $7,000,000 exclusion amount to use when he or she dies.

Portability of the exclusion will allow the assets to pass to the surviving spouse without the need to set up a bypass trust when the first spouse dies. The exclusion is portable (or transferable) from the first to die to the survivor. The surviving spouse will be able to access the entirety of the couples resources without the need to utilize a bypass trust.

Since 2001 couple clients of our office have overwhelming been using a type of estate plan which incorporates a “disclaimer” estate plan. This plan allows the surviving spouse to accept all of the assets of the first to spouse to die and disclaim only as much as is necessary to insure the surviving spouse does not have assets in his or her estate more than necessary to avoid paying an estate tax. An example, would be a couple with a $5,000,000 estate, divided equally between the husband and spouse. When the first spouse dies with a disclaimer plan in place the survivor would likely “disclaim” $1,500,000, allowing the amount to pass into the bypass trust. The surviving spouse could still use the assets in the bypass trust, but on a limited basis.

It would not be necessary under the concept of portability to create the disclaimer trust. Such an estate plan would likely still work under the concept of portability, without any need to change an existing estate plan for this reason alone.. All assets would pass to the surviving spouse who would then be able to use a $7,000,000 exclusion.

The crystal ball is still a bit murky, but it will likely clear very quickly in 2009. As details of any Democratic plan come forth we will keep you posted.

Welcome

Welcome to Brown and Brown, P.C.’s Estate & Gift Tax blog.   We will be updating this blog on a regular basis, so please check back often.