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AICPA: ESTATE AND TRUST PLANNING STRATEGIES IN 2013

By: Steven G. Siegel © 2013

I. FEDERAL ESTATE, GIFT, GST and INCOME TAXES AFTER ATRA A. The Estate Tax. 1. The American Taxpayer Relief Act of 2012 (ATRA) permanently provides for a maximum federal estate tax rate of 40 percent with an annually inflation-adjusted $5 million exclusion for estates of decedents dying after December 31, 2011. 2. The maximum estate tax rate for estates of decedents dying after December 31, 2010 and before January 1, 2013 is 35 percent with a $5 million exclusion (indexed for inflation for 2012 at $5.12 million).

3. The 40% estate tax rate and $5 million inflation-adjusted exemption are “permanent.” Accordingly, for 2013, the inflation-adjusted exemption amount is $5,250,000. This translates into a unified credit of $2,045,800 for 2013.

B. The Gift Tax 1. ATRA provides a maximum 40 percent gift tax rate and a unified estate and gift tax exemption of $5 million (inflation adjusted) for gifts made after 2012. 2. The maximum gift tax rate for gifts made after December 31, 2010 and before January 1, 2013 is 35 percent with a $5 million exclusion (indexed for inflation for 2012 at $5.12 million). Effective January 1, 2013, the maximum federal gift tax rate was scheduled to revert to 55 percent with an applicable exclusion amount of $1 million (not indexed for inflation), its levels before enactment of tax law changes in 2001 and subsequent legislation. 3. The 40% gift tax rate and $5 million inflation-adjusted exemption are “permanent”. As with the estate tax, for 2013, the inflation-adjusted exemption amount is $5,250,000. This translates into a unified credit of $2,045,800 for 2013. Note: Because there is no reduction in the exemption for gifts or deaths from the gift tax exemption available in 2012 ($5.12 million) the concern many raised about “clawback” is alleviated. (“Clawback” refers to the possibility that taxpayers who made substantial gifts in 2012 may have been hit with a higher estate tax if they took advantage of the $5 million gift tax exclusion but later died when the estate tax may have been smaller than that).

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C. The Generation-Skipping Tax 1. ATRA provides a maximum 40 percent generation-skipping tax rate and a generation-skipping tax exemption of $5 million (inflation adjusted) for gifts made after 2012. The GST exemption for 2013 is $5,250,000. 2. The maximum generation-skipping tax rate for gifts made after December 31, 2010 and before January 1, 2013 is 35 percent with a $5 million exclusion (indexed for inflation for 2012 at $5.12 million). Effective January 1, 2013, the maximum federal GST tax rate was scheduled to revert to 55 percent with an applicable exclusion amount of $1 million (indexed for inflation after 1996), or an anticipated exemption of approximately $1,400,000. 3. ATRA also extends a number of important GST tax-related provisions that were scheduled to expire after 2012. They include the GST deemed allocation and retroactive allocation provisions; clarification of valuation rules with respect to the determination of the inclusion ratio for GST tax purposes; provisions allowing for a qualified severance of a trust for purposes of the GST tax; and relief from late GST allocations and elections. All of these provisions were enhancements to the complex GST rules to make them easier to use, and all have been now made permanent.

II. Estate and Gift Taxation Issues for Same-Sex Married Couples

A. Generally

The Windsor case involved the estate tax marital deduction. Because of the Defense of Marriage Act (DOMA), same-sex married couples could not take advantage of the estate tax marital deduction and other provisions, such as portability. DOMA also precluded same-sex married couples from the benefits of special rules for gifts between spouses and from spouses. In Windsor, The Supreme Court declared a distinction between legal marriage under state law and legal marriage under federal law unconstitutional, and found that same-sex persons legally married by their state of residence were entitled to all of the federal laws regarding married persons.

B. Marital Deduction

1. Code Sec. 2056 provides an unlimited deduction from the gross estate for property passing from a decedent to a surviving spouse. Generally, the decedent must be survived by his or her spouse who is a U.S. citizen at the time of the decedent's death, the property interest must have passed from the decedent to the spouse, and the property interest must be a deductible interest. Additionally, the property's value must be ascertainable. The $5.25 million estate tax exclusion for 2013 for all estates (indexed for inflation) makes the use of the marital deduction unnecessary in many situations. However, as Windsor showed, it is a valuable tax benefit for larger estates. Many same-sex married couples should revisit their estate plans to make certain that interests passing to the other spouse qualify for the marital deduction and other tax benefits.

2. With the recognition of marriage, one-half of jointly-held property is

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included in the estate of the first spouse to die, regardless of contribution. Code Sec. 2040. The entire property qualifies for the federal estate tax marital deduction. Code Sec. 2056. There is a date of death basis adjustment for one-half of jointly-held property.

C. Portability

ATRA extended permanently the concept of portability, which generally allows the estate of a surviving spouse to utilize the unused portion of the estate tax applicable exclusion amount of his or her last predeceased spouse. Because of DOMA, only opposite-sex married couples could take advantage of portability. Same-sex married couples should now be permitted to take advantage of portability as part of their estate planning. The IRS is expected to issue guidance.

D. Gifts

Because of DOMA, only opposite sex married couples were allowed to "split" gifts to take advantage of a doubled annual gift tax exclusion ($14,000 for 2013, indexed annually for inflation) for a total tax-free gift of $28,000). Code Secs. 2523 and 2013. Same-sex married couples can now presumably transfer assets between themselves with no concern for lifetime gift tax consequences. This creates considerably greater flexibility for estate planning. The IRS is expected to issue guidance. Where one spouse is not a U.S. citizen, the annual exclusion from gift taxes for gifts made to the noncitizen spouse is $143,000 for 2013, indexed annually for inflation. III. New Medicare Tax Thresholds and Income Tax Rules of ATRA Relate Directly to Estate, Gift and Trust Planning 1. Multiple Thresholds Affect Individual Taxation a. The Medicare Tax Thresholds

1. ATRA was not about the Medicare Tax. However, since the Medicare taxes on earnings and on net investment income became effective for tax years beginning January 1, 2013, it is relevant to address its thresholds as part of 2013 tax planning.

2. Wage and self-employment income in excess of $250,000 (married couples filing jointly), $200,000 (heads of household and single filers) or $125,000 (married couples filing separately) will be subject to an additional Medicare tax of 0.9%. The total Medicare tax on these “excess” earnings will be 2.35%, which includes the 1.45% Medicare tax on earnings below these amounts. Employers must withhold the extra tax only for those employees earning more than $200,000, regardless of whether the employee is single or married. For married couples, if each spouse earns less than $200,000, but collectively they earn more than $250,000, estimated tax payments may be necessary.

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3. Individuals will also be subject to a 3.8% Medicare tax on the lesser of their net investment income or the excess of their “modified adjusted gross income” over the threshold amount ($250,000 for married couples filing jointly, $200,000 for heads of household and single filers, or $125,000 for married persons filing separately). Modified gross income means adjusted gross income increased by any otherwise excluded foreign earned income. 4. The thresholds for the Medicare taxes are not indexed for inflation. b. The Thresholds for the Phase-out of Personal Exemptions and Itemized Deductions

1. The deduction for personal exemptions will begin to be phased out at various levels of adjusted gross income depending on the taxpayer’s filing status. The phase out thresholds begin at $300,000 (married taxpayers filing jointly), $275,000 (heads of households), $250,000 (single taxpayers) and $150,000 (married taxpayers filing separately).

2. The limitation on itemized deductions (known as the “Pease limitation” named for the Congressman who introduced this (Rep. Donald Pease (D-OH)) also begins to apply at the same adjusted gross income thresholds as noted for the phase-out of the deduction for personal exemptions, namely $300,000 (married taxpayers filing jointly), $275,000 (heads of households), $250,000 (single taxpayers) and $150,000 (married taxpayers filing separately).

3. The thresholds for the personal exemption phase-out and the Pease limitation will be indexed for inflation after 2013. c. The Thresholds for the New 39.6% Tax Rate 1. The 39.6% rate applies to individuals if taxable income exceeds the following amounts: Married filing jointly: $450,000 Heads of Households: $425,000 Single Taxpayers: $400,000 Married Filing Separately $225,000 2. These threshold amounts are indexed for inflation after 2013. There is more discussion of the 39.6% rate thresholds below. d. Individual Income Tax Rates

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1. ATRA makes permanent for 2013 and beyond the lower Bush-era income tax rates for all taxpayers, except for taxpayers with taxable income above $400,000 ($450,000 for married taxpayers, $425,000 for heads of households). Income above these levels will be taxed at a 39.6 percent rate.

2. The 10, 15, 25, 28 and 33 percent marginal rates remain the same after 2012, as does the 35 percent rate for income between the top of the 33 percent rate ($398,350 for most taxpayers) and the $400,000/$450,000 threshold at which the 39.6 percent bracket now begins.

3. Individual marginal tax rates of 10, 15, 25, 28, 33, and 35 percent at the end of 2012, therefore, are now set going forward at the same 10, 15, 25, 28, 33, and 35 rates, but with an additional 39.6 percent rate carved out from the old 35 percent bracket range. The fiscal cliff agreement also uses the same $400,000/$450,000 taxable income thresholds to apply a higher capital gains and dividend rate of 20 percent, up from 15 percent (see discussion, at “Capital Gains and Qualified Dividends,” below).

4. The bracket ranges for the extension of the 35 percent rate now cover only a relatively small sliver of what had constituted the upper-income range. The range of the 35 percent tax bracket for 2013 because of the Bush-era rate extensions begins at $398,350, for all individual brackets, except half ($199,175) for married taxpayers filing separately. The 35 percent income bracket ranges for 2013, therefore, are:

$398,350 - $400,000 for single filers $398,350 -$425,000 for heads of household $398,350 - $450,000 for joint filers, surviving spouses $199,175 - $225,000 for married filing separately

5. Taxpayers who find themselves within the 39.6 percent marginal income tax bracket nevertheless also benefit from extension of all Bush-era rates below that level.

6. As with all tax bracket ranges, ATRA directs that the $450,000/$400,000 beginning of the 39.6 percent bracket be adjusted for inflation after 2013 based upon the standard formula of Code Sec. 1(f). Also relevant, however, the new law did not adopt recommendations that had been floated for several years that would lower the inflation- factor formula applied annually to all tax bracket ranges, thereby raising slightly more tax revenue each year.

7. Although these rates are now made “permanent,” nothing would stop Congress from reconsidering the entire tax rate structure again in the future, as part of overall tax reform or even earlier as debt ceiling negotiations get under way shortly.

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8. The majority of U.S. businesses are pass-through entities, such as partnerships and S corporations. Profits are passed through to their individual owners and therefore are taxed at individual income tax rates. A “C” corporation, with its current corporate level tax rate of 35 percent (which may drop if recent corporate tax reform proposals are adopted), may become more attractive with rates rising to 39.6 percent for some individuals.

e. Income Taxation of Trusts and Estates 1. ATRA similarly retains the Bush-era tax rates that apply to trusts and estates, except for the highest rate bracket. That top rate increases to 39.6 percent and applies to what was the entire 35-percent bracket range and, therefore, begins in 2013 for taxable income in excess of $11,950. Accordingly, there is no 35 percent bracket for trusts and estates. 2. Long-term capital gains and qualified dividends reach the 20 percent bracket for trusts and estates when the entity has taxable income in excess of $11,950. 3. Similarly, the Medicare tax on net investment income begins to impact trusts and estates with adjusted gross income in excess of $11,950. 4. Accordingly, the effective income tax rate on many trusts and estates will be 43.4 percent for income such as interest, rent, royalties, and short-term capital gains, and 23.8 percent for long-term capital gains and qualified dividends. 5. These thresholds are indexed annually for inflation. 6. The exceptionally low thresholds for trusts and estates suggest there will be increased pressure placed on fiduciaries to distribute income, since only undistributed income of the entity is subject to the income tax and Medicare tax. However, distribution of capital gains may not be a simple decision. What does the governing instrument say about distributions of principal? Is the trust a total return unitrust? What does the state Principal and Income Act provide? The new tax laws may suggest reconsidering the drafting of trusts and how principal distributions should be addressed. 7. Retaining assets in a trust for all of the “right” reasons – asset protection, management, creditor protection, addressing blended family issues, special needs provisions, concerns about a surviving spouse’s remarriage, elder care issues, etc. – has become more expensive. f. Capital Gains/Qualified Dividends Rules

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1. ATRA raises the top rate for capital gains and dividends to 20 percent, up from the Bush-era maximum 15 percent rate. That top rate will apply to the extent that a taxpayer’s income exceeds the thresholds set for the 39.6 percent rate ($400,000 for single filers; $450,000 for joint filers and $425,000 for heads of households). 2. For 2013, the maximum rate of tax on the adjusted net capital gain of an individual is 20 percent on any amount of gain that otherwise would be taxed at a 39.6 percent rate. 3. All other taxpayers will continue to enjoy a capital gains and qualified dividends tax at a maximum rate of 15 percent. 4. A zero percent rate will also continue to apply to capital gains and dividends to the extent income falls below the top of the 15 percent income tax bracket—to be $72,500 for joint filers and $36,250 for singles for 2013. Qualified dividends for all taxpayers continue to be taxed at capital gains rates, rather than ordinary income tax rates as prior to 2003.

5. The 28 and 25 percent tax rates for collectibles and recaptured Code Section 1250 gain, respectively, continue unchanged after 2012. Also unchanged is the application of ordinary income rates to short-term capital gains; only long-term capital gains, those realized on the sale or disposition of assets held for more than one year, can benefit from the reduced net capital gain rate.

6. “Qualified dividends” refers generally to dividends received from a domestic corporation or a qualified foreign corporation, on which the underlying stock is held for at least 61 days within a specified 121-day period before the stock goes “ex-dividend”, i.e. the date when a purchaser of the stock will not receive the imminent dividend. Certain dividends do not qualify for the reduced tax rates and are taxed as ordinary income. Those include (not an exhaustive list) dividends paid by credit unions, mutual insurance companies, and farmers’ cooperatives.

7. Installment payments received after 2012 are subject to the tax rates for the year of the payment, not the year of the sale. Thus, the capital gains portion of payments made in 2013 and later is now taxed at the 20 percent rate for higher-income taxpayers. 8. For planning purposes, consider favoring installment sales for 2013 and subsequent tax years as a way to “stretch out” gain recognition and increases in adjusted gross income and taxable income, keeping in mind the various thresholds with respect to the Medicare tax, the phase-out of personal exemptions and itemized deductions and the imposition of the 39.6 percent tax rate.

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9. It is possible that the higher tax rates for 2013 and later years may cause taxpayers to consider the use of a like kind exchange to defer the tax that might otherwise become due in the event of a sale. 10. As a result of the Medicare taxes and the increased rate on long-term gains and qualified dividends, starting in 2013, therefore, taxpayers within the net investment income surtax range must pay the additional 3.8 percent on capital gain, whether long-term or short-term. The effective top rate for net capital gains for many “higher-income” taxpayers thus becomes 23.8 percent for long term gain and 43.4 percent for short-term capital gains starting in 2013. This will be an especial costly tax increase for trusts and estates as a result of their low threshold of subjectivity to these new tax rules.

IV. Importance of Grantor Trusts in 2013 Income Tax Planning 1. With the imposition of the highest tax rate (39.6%) on trusts and estates at just $11,950 of income for 2013, the imposition of the highest rate on long-term capital gains and qualified dividends (20%) when the trust or estate passes $11,950 (for 2013) of taxable income, and the imposition of the 3.8% Medicare surtax on the undistributed net investment income of a trust or estate that has taxable income over $11,950, an “escape” can be found in the grantor trust rules. 2. If the grantor retains a power making the grantor taxable on the income of the trust, all of the applicable thresholds are tested at the level of the grantor, not at the level of the trust. Individuals are taxed at the 39.6% rate on ordinary income when they reach the taxable income threshold of $450,000 (married filing jointly) or $400,000 (single filers). The same thresholds apply to when individuals must pay the 20% rate of tax on long-term capital gains and qualified dividends. For individuals, the thresholds to be reached for imposition of the Medicare surtax on net investment income are adjusted gross income of $250,000 (married filing jointly) and $200,000 (single filers). 3. If the grantor is willing to bear the income tax burden on the trust’s income, it is likely that the burden may be imposed at a significantly lower rate on an individual than allowing it to fall on the trust. Moreover, by paying the income tax, the grantor is burning off assets (the tax dollars) that might otherwise have been included in the grantor’s estate, while at the same time allowing the trust (or its beneficiaries) to retain the trust income without having it reduced by the income tax liability. The grantor’s payment of the income tax liability has been ruled to be not a gift by the grantor to the beneficiaries of the trust. Rev. Rul. 2004-64.

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V. ROADMAP FOR THE GRANTOR TRUST RULES: CODE SECS 671-678

Code Section 671: Basic Grantor Trust Rules: The Grantor is taxed on the trust income if the Grantor has a power within Code Sections 673-678. The trust is not a separate taxpayer. The character of income passes through to the Grantor. All tax issues apply at the Grantor level. Code Section 672: Definitions and Rules. Adverse Party: A holder of a substantial beneficial interest in the trust; can be adversely affected by the exercise or non-exercise of a power. Non-Adverse Party: Any person not an adverse party. Related or Subordinate Party: A non-adverse party who is related to the Grantor (Certain family members, entities, employees) Independent Trustee: Someone not related or subordinate to the Grantor. Spouse: A Grantor holds any interest or power held by his or her spouse from and after marriage. A spouse cannot be an adverse party. Code Section 673: Reversionary Interests If a Grantor or the Grantor’s spouse holds a reversionary interest in a trust greater than 5 percent, the Grantor is the owner of the entire trust. 673(a). Exception: If the reversion results from the death of an income beneficiary prior to age 21, who is a lineal descendant of the Grantor, the rule does not apply. 673(b). Code Section 674: Power to Control Beneficial Enjoyment Broad General Rule: The Grantor is the owner of a trust if the beneficial enjoyment is subject to a power of disposition by the Grantor or a nonadverse party without the consent of an adverse party. 674(a). Numerous Important Exceptions to the General Rule: The Grantor will not be treated as the owner of the trust if certain defined powers are held – enumerated in 674(b). (These exceptions include the power to distribute trust principal when limited by an ascertainable standard, the power to allocate between income and principal, etc.). Another Exception: The broad rule of 674(a) does not apply if certain (but not all) powers may be exercised only by an independent trustee. 674(c).

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Code Section 675: Administrative Powers Certain enumerated administrative powers if held by the Grantor or the spouse of the Grantor will make the trust a grantor trust. These include the power to borrow the trust income or principal without providing adequate interest or adequate security and the power exercisable in a in a non-fiduciary capacity to substitute property for the property held in the trust. Code Section 676: Power to Revoke The power to revoke the trust, if held by the Grantor or the Grantor’s spouse, will make the trust a grantor trust. Code Section 677: Income for Benefit of Grantor A trust will be a grantor trust if the Grantor or a nonadverse party can use the trust income for the benefit of the Grantor or the Grantor’s spouse without the consent of an adverse party. 677(a). The “use” of the income can be immediate, or future, or the income can be used to pay life insurance premiums on policies on the life of the grantor or the grantor’s spouse. Exception: Trust income will not be taxed to the Grantor if it can be used to discharge the Grantor’s support obligation – unless it is so used. 677(b). Code Section 678: Person Other Than Grantor Treated as Substantial Owner A non-Grantor will be treated as the owner of a trust if such person has the power to vest the trust property in him or herself. 678(a). Exception: If the trust Grantor is already treated as the taxable owner of the trust, Section 678 will not apply. VI. PORTABILITY: AN ESTATE PLANNING GAME-CHANGER

A. What is Portability 1. The American Tax Relief Act of 2012 (“ATRA”) makes permanent “portability” between spouses. The portability rules were originally passed as part of the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (the “2010 Act”) and initially were effective for 2011 and 2012 only. Portability is now a permanent part of the transfer tax law. 2. In the 2014 Budget Proposals of the Obama Administration, there are provisions presented to reduce other “permanent” parts of ATRA – i.e. the estate and gift exclusion amounts allowed by ATRA, (the gift amount from $5,250,000 in 2013 indexed

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for inflation to $1 million with no indexing; the estate exclusion from $5,250,000 in 2013 indexed for inflation to $3.5 million with no indexing); and increase the tax rate from 40% to 45% (all proposed to take effect in 2018). Significantly, however, there is no Proposal to change the portability provisions. Portability seems to be a permanent part of the transfer tax law, despite the most recent “tinkering” proposals. 3. Portability allows the estate of a decedent who is survived by a spouse to make a portability election to transfer the decedent’s unused federal transfer tax exclusion (referred to as “the deceased spousal unused exclusion amount” or “DSUE”) to the surviving spouse so that the surviving spouse may then use the DSUE obtained from the deceased spouse to address the survivor’s own transfers during life and at death. ATRA provides that the basic exclusion amount is $5 million for 2011, indexed for inflation annually thereafter. The 2013 basic exclusion amount is $5,250,000. Example 1: Husband (H) dies in 2011, leaving surviving Wife (W) outright an estate of $5 million. None of H’s DSUE has been used. In 2013, W has H’s $5 million DSUE plus her own inflation-adjusted $5.25 million basic exclusion amount (a total of $10.25 million) for gift and estate tax purposes. Example 2: W died in 2011, leaving all of her estate ($5 million) to her children from her first marriage. H survives W. In 2013, H has his own $5.25 million basic exclusion amount, but received no DSUE from W. Example 3: Assume in Example 2, W left $2 million to her children, using $2 million of her basic exclusion amount, and her remaining $3 million to H using the unlimited marital deduction. Now, in 2013, H would have a DSUE from W of the $3 million unused exclusion, plus his own $5.25 million exclusion, for a total gift and estate tax exclusion of $8.25 million. B. What is Portability Intended to Accomplish? 1. The legislative purpose of portability is to create “fairness” between those people who “plan” their estates and those who fail to do so. It preserves the unused portion of the deceased spouse’s exclusion which might otherwise have been lost through inadvertence. 2. It is designed to eliminate the need for many married couples to retitle their assets and maintain assets in the separate names of each spouse. It is designed to not force the creation of complex trusts (referred to as “credit shelter trusts” or “bypass trusts”) at the death of the first spouse to be certain the transfer tax exclusion available to the first decedent is properly used. 3. The portability rules are effective for the unused exclusion amount of the deceased spouse who dies after December 31, 2010. This amount is available to the

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surviving spouse in addition to the surviving spouse’s own applicable exclusion amount. (Code Section 2010(c)(5)). 4. Portability has no application to a decedent who died prior to January 1, 2011. 5. Certain observations must be made about portability, especially with respect to those estates which may be larger, rather than smaller, namely: a. While the basic exclusion amount for those persons living is indexed annually for inflation, the DSUE is not indexed for inflation. b. The unused generation-skipping transfer tax exemption of a predeceased spouse is not portable. c. To date, state death tax exemptions have not been made portable, and will not be unless a state has adopted the federal rules for portability. C. Portability Applies Only to the Unused Exclusion of the Last Deceased Spouse. 1. In a situation where a surviving spouse is predeceased by more than one spouse, the amount of the DSUE that is portable and available to be used by the surviving spouse is limited to the lesser (for a death in 2013) of the basic exclusion amount of $5,250,000 or the unused exclusion amount of the last deceased spouse. 2. If the last deceased spouse has no unused exclusion available, the surviving spouse gets no benefit from portability – the unused exclusion of an earlier deceased spouse cannot be used in such a case, and is irrevocably lost. If none of the last deceased spouse’s basic exclusion was used, the surviving spouse gets (for a death in 2013) the entire DSUE of $5,250,000 from the deceased spouse, and may use his or her own basic exclusion amount as well. As indicated above. the basic exclusion amount is $5 million, indexed annually for inflation from 2011. 3. A surviving spouse may use the predeceased spouse’s DSUE in addition to such surviving spouse’s own 2013 $5,250,000 exclusion for transfers made by the surviving spouse either during lifetime or at death. 4. Can late elections be forgiven and corrected later? There is speculation that the IRS will allow so called “Section 9100 relief” to make a late election without penalty so long as all filings have been consistent with any late election, and the interests of the government have not been prejudiced, but there has not been any official word on this issue to date from the IRS. D. An Election is Required for Portability to Apply. 1, Portability is elective, rather than automatic. Temp. Reg. 20.2010-2T(a). In order for a surviving spouse to be allowed to use the DSUE amount of a predeceased

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spouse, an election must be made on a timely filed federal estate tax return (Form 706) (including extensions) filed for the estate of the predeceased spouse, regardless of the size of the gross estate, i.e. regardless of whether the estate of the predeceased spouse is otherwise required to file an estate tax return. 2. Form 706 must be filed in any event for a decedent whose gross estate exceeds the basic exclusion amount reduced by adjusted taxable gifts. Code Section 6018. (Adjusted taxable gifts refers to all gifts made by a donor after December 31, 1976 in excess of the annual gift tax present interest exclusion amount)

3. There are no special boxes to check or statements to make on Form 706 in order to make the portability election. Form 706 is due nine months after a decedent’s date of death. Requests for an automatic six-month extension of time to file must be made on Form 4768 filed before the due date of Form 706.

4. Not timely filing Form 706 will effectively prevent the portability election. As indicated above, estates of decedents dying before January 1, 2011 are not entitled to make the portability election.

E. Should “Small” Estates Bother to File Form 706 to Elect Portability?

1. There may be a tendency on the part of representatives of “small” estates to decide that making this election is not necessary, since it may be assumed that there is “no chance” that the estate of the surviving spouse would ever reach the level of the DSUE plus the surviving spouse’s own basic exclusion amount. Certainly there is a cost involved in preparing the Form 706, a cost that the decedent’s family may resist. 2. It is submitted that this is not the correct decision. What if the surviving spouse receives a “windfall” after the first spouse dies? This could occur as an unexpected inheritance, a winning lottery ticket or casino visit or by being an injured plaintiff in a personal injury case. What if the surviving spouse remarries a wealthy person, making the DSUE more “valuable”? Had the representative of the first decedent spouse simply elected portability, the additional exclusion would be available to the surviving spouse. If the windfall does occur, and if no portability election was made, might the representative of the estate of the first decedent be sued for negligence by the heirs of the second spouse to die? Count on it! Query: Did the executor get a signed letter from the beneficiaries of the estate of the first decedent absolving the executor from any responsibility for failure to make the election? 3. While the representative of the estate of the first decedent spouse would appear to be on the “front line” of possible liability exposure, what about the other advisors of the decedent’s estate and the surviving spouse – the attorneys and/or accountants in the picture? Is there any risk or vulnerability there? How carefully was the client advised – and what proof is there of that advice?

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4. Note that the requirement to file Form 706 to make a portability election will require more filings of federal estate tax forms than would have previously been the case, especially with respect to relatively small estates well below the threshold required to pay taxes, but for which it is certainly advantageous and proper to make the portability election. F. Advantages and Disadvantages of Portability. 1. Simplification. The most obvious advantage of portability is that it simplifies the estate planning process for many people. It will eliminate for many married people the need to divide their assets and hold them in the separate names of the spouses. Its use will provide a stepped-up basis in the assets left to the surviving spouse which remain unspent at the surviving spouse’s death. Portability may eliminate for many families the use of a bypass (credit shelter trust). Such a trust may not be needed for federal estate tax reduction over two deaths, so that it will not be used. 2. Retirement Plan Roll Over Advantage. Portability can be a major advantage when the decedent has a large retirement plan. Before portability there may have been a dilemma as to whether to leave the plan to the surviving spouse to take advantage of the rollover opportunity, favorable deferral and distribution rules, etc. – or leave the plan to a bypass trust as perhaps the only family asset large enough to absorb the available applicable exclusion. This latter disposition may have saved estate taxes over two deaths, but may have resulted in faster required minimum distributions and increased income tax liability. With the increased exclusion and the portability option, persons with large retirement plans will be more likely to leave them outright to their spouses and retain the spousal rollover as a viable planning option. 3. Planning for States with Independent Death Taxes. a. States that have decoupled from the federal estate tax system must be taken into account in planning, particularly with the higher applicable exclusion available under federal law. What planning is appropriate in circumstances where there may still be a state death tax regardless of the fact that there may not be a federal estate tax as a result of the estate falling short of the federal exclusion, but exceeding the state exclusion? b. Be careful of planning that directs an entire estate to pass to a credit shelter trust. While this may be a good idea under the federal system with the enhanced federal exclusion, it may result in a very substantial state estate tax at the death of the first spouse to die. Where the federal applicable exclusion is $5,250,000 and a credit shelter trust of that amount is funded, the state estate tax liability in most decoupled states will be $478,182. c. Similarly, be careful of ignoring the presence of a state death tax exclusion at the first death of a married couple. If everything is left to the surviving spouse, taking advantage of the unlimited marital deduction and portability, there will be

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no state death tax at the first death, but no use of any state exclusion for the deceased spouse. That will mean more assets will likely be subjected to taxation at the second death, at least some of which tax liability could have been avoided if the state death tax exclusions were used at each death. 4. Is the Simple Plan the Better Plan? a. The intentional rejection of a bypass trust can be viewed as either an advantage or a disadvantage. It gives more control over property to the surviving spouse. In some families this is viewed as an advantage, in others a disadvantage. Issues of asset protection, management, protection from future spouses of the surviving spouse and spouses of children, protection of blended family heirs of one spouse but not the other, ultimate control of the disposition of the property by the first spouse to die, etc. must be considered as part of the portability discussion. Especially in situations where there is a blended family, or serious concerns about asset protection, remarriage or management with respect to the surviving spouse, it is suggested that the “simplicity” of the portability election may be outweighed by the protection of the bypass trust at the first death. b. What happens if the assets left by the first decedent appreciate dramatically during the lifetime of the surviving spouse – who may survive the first decedent by many years? If portability is used, all of the appreciated property will be taxable at the death of the surviving spouse. Portability is not indexed for inflation, so the DSUE of the first decedent is “frozen” and offers no help to address significant appreciation and inflation. Had the credit shelter bypass trust been used instead of portability at the first death, the appreciation would stay with the credit shelter trust, which would not be subjected to transfer tax at the second death. 5. The Dilemma: Appreciation/Inflation Protection vs. Basis Step-Up Advantage a. As indicated above, portability is not indexed for inflation. Portability does not apply to the decedent’s unused GST exemption. However, portability has the advantage of providing a “second” step-up in basis of the assets of the first decedent spouse. The first step-up occurs when the first spouse dies; the second occurs when the surviving spouse dies, having inherited the assets of the first spouse – Code Section 1014. Especially with higher income tax rates for wealthy individuals and the new Medicare surtax effective in 2013, higher income tax basis and potentially reduced capital gains are valuable planning opportunities. b. Using the credit shelter bypass trust gets a basis step-up at the first death, but not at the second death. Compare the advantage of the basis step-up using portability with the appreciation and inflation protection for the estate of the second spouse to die using the bypass trust. A possibly very difficult case-by-case analysis. VII. Make Sure the Clients Understand the Plan They Have - Concerns in 2013 with Formula Clauses in Wills and Trusts

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A. The Potential Problem with Formula Clauses.

1. Given the significant permanent increase in the applicable exclusion, what is the effect of a formula clause in a client's will or trust? For example, if a document says, "I leave the amount of the federal applicable exclusion to my children and the balance of my estate to my spouse", how much has this person left to children? If death occurs in 2013, that would be $5,250,000. What, if anything is left for the spouse? The spouse may be forced to make an election against the decedent’s will in such a case. If this is a blended family where the children are those of the first decedent spouse, but not the children of the surviving spouse, what is the intent of the decedent to “balance” assets between the spouse and the children? 2. What if the formula clause leaves the surviving spouse “the minimum amount necessary to reduce my taxable estate to zero, remainder to my children”? Arguably, if the estate is $5,250 000 or less, nothing need pass to the spouse to reduce the taxable estate to zero, since it is already there. 3. Wills and trusts written before 2011 and 2012 were signed when the federal estate tax exemption was significantly less than $5 million. All wills and trusts with formula clauses should be reviewed and a determination made as to what the testator/grantor intended when the will or trust was written.

B. Planning in 2013 to Address Formulas and Beneficiaries 1. What should we be telling our clients to do in the new planning climate of 2013? We have to be aware that our clients do not want to revise their estate planning documents every time the wind shifts. Many take the position that if we are not sure what to do, we should do nothing. That conclusion, however, may depend on what their current documents say and do. Many will rely on the 2013 $5,250,000 exclusion, indexed for inflation, the new portability rules and the $10,500,000 exclusion over two deaths to do little or no tax planning – keeping everything as simple and inexpensive as possible. Many clients with a simple “I love you” will – leaving everything outright to the surviving spouse – will consider their estate planning needs to have been met. Clients should always be made aware that a “wait and see” attitude – and do nothing in the interim – may not be appropriate, particularly if issues such as disability, incapacity, injury, etc. suddenly and unexpectedly arise. 2. Consider the use of “caps” and “ceilings” in conjunction with formula clauses. Language stating a formula clause but modified with a statement such as “but not an amount less than” or “but not an amount greater than” may be helpful to avoid an entirely unanticipated consequence as the result of changes in the law. 3. When was the last time the client checked his or her retirement plan beneficiary designations? The U.S. Supreme Court has made it clear that the named beneficiary of a retirement plan is entitled to all of the plan benefit – notwithstanding a

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spouse’s waiver of those rights under a divorce decree. The designated plan beneficiary when the participant dies gets the benefit. Kennedy v. Plan Adm’r for DuPont Sav. And Inv. Plan, 129 S.Ct. 865 (2009). Have your clients make sure all plan designations are up to date! VIII. General Estate Planning Opportunities Suggested by ATRA A. Planning for Gifting Issues. 1. The federal gift tax rate is 40% for 2013 and beyond. The exemption is $5,250,000 for 2013 and will be adjusted annually for inflation. For most clients, especially those that are married, an available exclusion of $10,500,000 (increasing annually) will cover all the gifts they wish to make. For clients at higher levels of wealth, larger gifts may be considered, with the gift tax paid at the “advantageous” 40% rate. This could accomplish several objectives. First, if the client dies more than three years after making the gift, there is no "gross up" of any gift tax paid. Second, the payment of gift tax will avoid paying estate tax on the same assets (which may have appreciated significantly in value) if they are held until death. Note that the gift tax is “tax exclusive”, while the estate tax is “tax inclusive”. A simple example of this point is that if the donor with 140 units of property gives the donee 100 units of property while alive, the donee receives 100 units and the government receives 40 units of tax in 2013. If the donor makes no gift, and dies with 140 units of property in 2013, the heir will receive 84 units of property and the government will receive 56 units of tax. 2. Valuation discounts remain available under the law. Legislation has been proposed to limit discounting in transfers to family members – nothing has been enacted to date. If possible, take advantage of the “defined value clause” opportunity approved in Wandry v. Commissioner, TC Memo 2012-88. This case allowed the use of a formula allocation clause limited to a specific gifted amount. If the IRS challenged the valuation, the number of units of property given would be adjusted to the amount of the intended gift, thereby eliminating any audit risk of an unwanted gift tax liability. The IRS filed a notice of appeal in Wandry in August of 2012. The IRS subsequently withdrew the notice of appeal, but instead issued a nonacquiescence in the case. IRB 2012-46. Careful here – more IRS challenges of this issue are anticipated. 3. For the most part, state gift taxes are not an issue, since only Connecticut and Minnesota presently have an independent gift tax. 4. Bear in mind that property transferred by gift requires a carryover of the donor’s basis to the donee (Code Section 1015) whereas property transferred at death permits a stepped-up basis to date of death value. (Code Section 1014). This point suggests paying careful attention to the property that is being gifted not only from the standpoint of value, but also with respect to the basis and possible appreciation in the hands of the donor.

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5. Consider making gifts of low basis and/or dividend-producing property to persons who are in lower tax brackets (the 10% and 15% brackets) and who are not subject to the Kiddie Tax. These persons may be in the zero % tax bracket for 2013 with respect to their receipt of qualified dividends and realization of long-term capital gains. This would be the case for single filers having adjusted gross income of $36,250 or less, and joint filers with adjusted gross income of $72,500 or less. Persons such as children over age 19 who are not full time students, children who have graduated college but who are unemployed or who are earning low income, or parents with little income may all be “candidates” for this planning. 6. Remember that payments of tuition directly to an education provider and medical expenses directly to a medical care provider are not considered gifts at all. Where appropriate, consider prepayment of these expenses. 7. Consider gifts to grandchildren – either outright or in trusts for their benefit. The generation-skipping transfer tax exemption is $5,250,000 in 2013, indexed for inflation thereafter.

B. Loans to Family Members With interest rates at or near record lows, an excellent estate reduction technique involves making loans to one's children or grandchildren. Extending credit to a family member is not a gift if the lender receives in return a note that bears interest at the appropriate Applicable Federal Rate (AFR). August 2013 rates are: AFR 2.0%; Short-term loans (up to three years): 0.28%; Mid-term (4 to 9 years) 1.63%; Long-term (10 years or more) 3.16%. C. Planning for States with Independent Death Taxes. 1. States that have decoupled from the federal estate tax system must be taken into account in planning, particularly with the higher applicable exclusion available under federal law. What planning is appropriate in circumstances where there may still be a state death tax regardless of the fact that there may not be a federal estate tax as a result of the estate falling short of the federal exemption, but exceeding the state exemption? 2. Be careful of planning that directs an entire estate to pass to a credit shelter trust. While this may be a good idea under the federal system with the enhanced federal exemption, it may result in a very substantial state estate tax. When the federal exclusion was $3.5 million, and a credit shelter trust of that amount was funded, the state estate tax liability in most of the decoupled states was $229,200. With the federal applicable exclusion at $525 million, and a credit shelter trust of that amount is funded, the state estate tax liability in most decoupled states will approach $480,000. Similarly, be careful of ignoring the presence of a state death tax exemption at the first death of a married couple. If everything is left to the surviving spouse, taking advantage of the unlimited marital deduction and portability, there will be

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no state death tax, but no use of any exemption for the deceased spouse. That will mean more assets will likely be subjected to taxation at the second death, at least some of which tax liability could have been avoided if the state death tax exemptions were used at each death. D. Charitable Giving. 1. With the higher applicable exclusion, tax-motivated charitable planning for most clients will not be necessary. That suggests the reduced use of testamentary charitable bequests and testamentary charitable lead trusts for most clients. With the large estate tax exclusion (as indexed) in effect, consider leaving bequests to heirs that are “trustworthy” and suggest (do not require) that they make an appropriate gift to charity. If that is done, there is no tax benefit lost to the decedent’s estate – but there is an income tax benefit gained by the heir who makes the charitable donation.

2. Give assets to charity that are income in respect of a decedent (IRD) assets (such as retirement plans or installment notes). Otherwise, these assets will be includable in a decedent’s estate and be taxable income to the decedent’s heirs. The combination of the federal estate and income tax and, if applicable, state estate and income taxes can result in a tax rate in excess of 60% on these assets. 3. Charitable remainder trusts (CRTs) will have several suggested uses. CRTs are split-interest trusts that include an annual annuity percentage income interest payable to the donor or to a noncharitable beneficiary during the trust term, with the remainder interest paid to the designated charity. a. Use a CRT to receive a gift of appreciated property from the donor, giving the donor a charitable contribution deduction. Have the charity sell the property and realize the gain – which will not be taxed to the charity. When the charity distributes its annuity payment to the beneficiary, it is taxable – but the income is spread out – making it more likely that higher capital gains and Medicare surtax thresholds can be avoided. b. Use a CRT with a variety of family members as the non- charitable lifetime beneficiaries (children, grandchildren, etc). The CRT receives and sells appreciated property. Payments are made to the chosen beneficiaries for a period of years (not to exceed twenty). Again, the donor may receive an income tax deduction for the actuarial value of the charitable gift, and the higher capital gain and Medicare surtax thresholds can be avoided. c. A CRT can be used in connection with retirement planning for those persons in a high tax bracket presently who anticipate being in a lower bracket when they retire. Here, a planning technique called a “NIMCRUT” may be suggested. This is a Net Income Makeup Charitable Remainder Unitrust. Assets are transferred to the CRT and then sold. The trust provides that the donor is to be paid the lesser of the net income of the trust or a fixed percentage of the trust’s annual income until retirement. If

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the trust income is less than the required fixed percentage, the “shortfall” is added to a makeup account to be paid to the donor in the future. While the donor is working, the trust assets are invested in low-yielding investments. Upon retirement, when the tax bracket of the donor declines, the assets are invested to maximize income, thereby using the makeup account to supplement the fixed annual payout requirement. 3. Consider using a charitable lead annuity trust (CLAT). (A trust where the charity’s interest comes first – an annual annuity to charity for a fixed number of years, with the remainder left after the charity’s interest to family members). With the low Section 7520 rate (the AFR), the CLAT actuarial calculation results in a higher present value of the charity’s annuity interest in the property used to fund the trust, and a corresponding lower value for the gift of the remainder interest to the grantor’s heirs. E. Planning May Depend on the Size of the Client’s Estate 1. Estates Under $5,250,000, as Indexed

a. Focus the client on income tax planning. Be sure the basis step-up is obtained at the first death. A simple plan for the surviving spouse (outright or a trust, QTIP or general power of appointment) may be favored. b. Address portability, taking into account the considerations noted above. c. Consider if a trust should be required solely to address the issue of an applicable state death tax. d. The client may well opt for the simplicity of planning offered by portability. In such a case, make sure Form 706 is filed when the client dies. 2. Estates in the $5,250,000 to $10,500,000 Range, as Indexed a. Major decision: Compare portability vs. the use of a credit shelter trust. What are the assets of the decedent? Are major retirement plan assets present? Are assets likely to appreciate over time? If so, the basis step-up over two deaths becomes important. How old is the surviving spouse? Will assets likely be spent down or accumulated by the survivor? b. Address carefully the issues of management, blended family, asset protection, future inflation, concerns about remarriage of the surviving spouse, undue influence, etc. c. Are gifts to grandchildren an issue? If so, since there is no portability of the GST exemption, consider a credit shelter trust here. 3. Estates Exceeding the Applicable Exclusion Amount

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a. Planning should address the same issues that were considered pre-ATRA. The credit shelter trust should be used at the first death of a married couple. b. The techniques discussed below remain viable at the present time, but are being “reviewed” by the federal government and may be limited by future legislation. The recommendation is to act sooner rather than later if any of the planning techniques discussed below are applicable to a client’s situation.

IX. Flexible Planning is Essential for 2013 and Beyond A. Dividing and Allocating Assets to Utilize the Federal Estate Tax Exclusion 1. Before portability, in the ideal planning situation, each spouse of a married couple had at least the amount of the applicable exclusion in separate names or in their individually created and controlled revocable trusts. If the couple resides in a community property state, the community property assets are allocated equally between them. Where this ‘ideal” situation exists, there is no need to move assets between the spouses, and drafting can be easily done to take full advantage of the federal estate tax exemption. The first to die spouse will have sufficient assets available to fund a bypass trust at the first death, and utilize the available applicable exclusion in full. 2. With portability, this planning may become unnecessary, especially in estates not likely to be taxable over two deaths, as the exemption will not be “wasted” if it is not used at the first death, assuming appropriate elections, etc. are made to take advantage of portability. 3. That said, adhering to this planning has become increasingly difficult. Issues concerning the desirability of holding property in joint names with right of survivorship, fears between the spouses of separate property control, disproportionately-owned retirement plan accounts, large life insurance policies payable to a spouse, business assets the ownership of which cannot be split between spouses, etc. makes simple asset division impractical, if not impossible for some families. B. A Flexible Planning Suggestion - The Disclaimer Trust Solution 1. A popular solution to the problem of how to divide an estate to assure full use of the applicable exclusion over two deaths is the use of a qualified disclaimer. Code Section 2518. This has been a popular planning choice since the 2001 Act. Should its use be continued in light of ATRA 2012? 2. The “disclaimer plan” suggests that each spouse leave all or substantially all of his or her assets to the other spouse, with a “disclaimer path” leading to a properly drawn bypass trust. If the planning is successful, when one spouse dies, the survivor will disclaim the optimal amount of property necessary to exactly fund the bypass trust created by the first decedent’s estate plan. The amount disclaimed will be

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equal to the maximum applicable exclusion available in the year of the first spouse’s death. The balance of the first decedent’s property will be retained by the surviving spouse, to qualify for the marital deduction. When the survivor dies, the property in the bypass trust will not be part of the survivor’s estate, and the balance of the survivor’s property will be sheltered in whole or in part by the applicable exclusion available in the year of the survivor’s death. The goal of allowing the maximum amount of property to pass through two estates with the least tax being imposed will be attained. 3. A spouse may be a beneficiary of a disclaimer trust under an exception to Code Section 2518's general qualified disclaimer rules that otherwise prohibit a disclaimant from accepting the benefits of the disclaimed property. Code Section 2518(b)(4)(A). This rule makes the spouse much more willing to “balance” tax-saving for the family and self-interest where neither has to be sacrificed. 4. A “typical” disclaimer trust may contain provisions granting the surviving spouse generous benefits in the bypass trust to be funded by the disclaimer. The survivor may be entitled to the income of the trust as well as principal in the discretion of the trustee, albeit limited by an “ascertainable standard” addressing support, health, maintenance and education. The survivor may also be given a “5 and 5 power”, to withdraw from the trust the greater of 5% of the trust principal or $5,000, on an annual, non-cumulative basis. The survivor should not, however, be given any special (limited) power of appointment over the trust property (unless the power is limited by an ascertainable standard) since possession of such a power would be viewed as giving the surviving spouse the right to direct the beneficial enjoyment of the disclaimed property, which is inconsistent with the definition of a qualified disclaimer. Reg. 25.2518-2(e)(2). 5. The advantage of continuing the use of this planning is to “hedge” against increasing applicable exclusion amounts (by inflation adjustments) in years beyond 2013.With large exemptions and portability, the likelihood is that fewer surviving spouses will exercise the disclaimer option. That may or may not be a positive outcome – depending on the impact of all of the non-tax advantages of trusts (asset protection, etc.) noted above. 6. The disclaimer planning option will not work in every case. Forces of fear, greed, grief, etc. may work against a disclaimer decision. The disclaimer must be accomplished within nine months of the decedent's date of death. There may be multiple marriages or blended families involved to complicate selecting the disclaimer technique. Where the disclaimer is unlikely or inadvisable, what alternative planning is available? C. Another Flexible Planning Suggestion: The Contingent QTIP Trust Solution or “Clayton” QTIP Trust 1. Where the spouses lack confidence that the survivor will follow through with the disclaimer planning, or where there is concern that the survivor may accept the benefits of the estate before a disclaimer can be filed, another planning solution is the contingent or “Clayton” QTIP trust.

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2. Here, each spouse leaves his or her assets to a trust designed to qualify as a QTIP trust. The executor of the first decedent’s estate (not the spouse) decides how much property to qualify for QTIP treatment. This designation removes the post-mortem qualification decision from the surviving spouse and places it within the control of a presumably more objective party. The property not elected to qualify as QTIP property typically passes into a credit shelter trust, often for the lifetime benefit of the surviving spouse. Regs. 20.2056(b)-7(d)(3) and 20.2056(b)-7(h), Ex. 6; Estate of Clayton v. Commissioner, 976 F.2d 1486 (5th Cir. 1992). X. Freeze Values at Current Levels for Senior Generation Clients A. Estate Freezing Transactions: Installment Sales

1. Use an installment sale to accomplish this “freeze” result. An asset is sold to a junior family member (based on an independent appraisal and for fair market value to eliminate gift tax issues) in exchange for a note which bears a market rate of interest at the applicable federal rate. Code Section 7520. The future appreciation of the transferred asset inures to the benefit of its new owner. If the transferor dies before the note is paid in full, the balance due on the note is an asset of the decedent-transferor’s estate. The seller retains cash flow from the transferred asset, no gift has been made, and the death tax value of the transferred property is “frozen” at the amount of the balance due on the note. All appreciation in excess of the Section 7520 rate is removed from the seller’s estate. 2. The seller may forgive the installment payments as they come due, utilizing the seller’s available gift tax exclusions. The issue may then become: Was forgiveness of the debt the seller’s intention from the outset of the transaction, in which case the IRS may attempt to recharacterize the transaction as a “disguised” gift from inception, and require reporting the entire value of the transferred property as a gift. Rev. Rul 77-299, 1977-2 CB 343. To avoid this result, avoid a commitment to forgive the debt at the outset of the transaction, and avoid a regular, predictable pattern of annual debt forgiveness.

B. Estate Freezing Transactions: The Self-Canceling Installment Note (SCIN).

1. The SCIN transaction takes the installment sale freeze a step further.

The SCIN involves the sale of property in exchange for an installment note calling for payments at a specified interest rate over a set period of time, which note payments terminate upon the death of the seller. The term of the note should not extend beyond the seller’s actuarial life expectancy. Since death terminates the seller’s right to receive payments, there is nothing of value to include in the seller-decedent’s estate. The potential gift tax issue is avoided by reflecting the self-canceling feature as part of the bargained-for consideration for the sale, by either placing a premium on the price to be paid for the property or by stating an interest rate substantially above the market rate.

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2. Since the note, by its terms, is canceled by the noteholder’s death, the value of the note is excluded from the decedent’s estate. Estate of Moss v. Commissioner, 74 TC 1239 (1980); acq. 1981-1 CB 2. Estate of Costanza, 320 F. 3d 595 (6th Cir. 2003). There must be an expectation of full repayment and the intent to enforce the collection of the indebtedness. The note may be secured. 3. The termination of a SCIN has potentially adverse income tax consequences. The unrealized or unreported installment sale gain must be reported in the year of the seller’s death on the fiduciary income tax return for the decedent’s estate on the basis that the deferred gain was income in respect of a decedent transferred by the decedent’s estate. Frane v. Commissioner, 998 F. 2d 567 (8th Cir. 1993). 4. The SCIN works best if the seller dies soon after the property is transferred, i.e. the less the buyer must pay, the greater the estate tax benefit realized. Accordingly, SCIN transactions are most often used for persons whose actual life expectancy is expected to fall short of their actuarial life expectancy. However, where the seller dies within a short time of entering into the SCIN transaction, the IRS is allowed to disregard the actuarial tables in such circumstances. The actuarial tables must be used to determine the seller’s life expectancy provided it can be shown that the seller has at least a 50% probability of surviving for more than one year from the date of the sale (Reg. 20.7520-3(b)). C. Estate Freezing Transactions: Sale to an Intentionally Defective Grantor Trust. 1. Overview. This technique combines favorable estate tax planning with advantageous income and gift tax planning. The grantor creates a trust for the benefit of family members, and sells assets to the trust in exchange for a long-term installment note. The sale is made for fair market value per appraisals, etc., (including valuation discounts) so that the sale by the grantor to the trust is not treated as a gift to the trust beneficiaries. 2. How the Trust is Designed and Created. The trust is drafted to treat the grantor as the owner of the trust for income tax purposes, but not for estate tax purposes. This is accomplished by including certain grantor-retained administrative powers in the trust (such as the power to substitute trust assets of equivalent value in a non-fiduciary capacity as approved by Rev. Rul. 2008-22 and most recently by Rev. Rul. 2011-28 which allowed a power of substitution over a life insurance policy without deeming such power a retained incident of ownership by the insured) which cause the grantor to be treated and taxed for income tax purposes as the trust owner (Code Sections 671-678) but not to be treated as the trust owner for estate tax purposes (the retained powers fall short of the powers required for inclusion in the

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grantor’s estate - Code Sections 2036-2038). The trust is thus “defective” for leaving the grantor subject to income tax, but “intentionally” so, since this was done by design. 3. Sale of Assets to the Trust. With the trust so prepared, the sale of assets by the grantor to the trust avoids capital gain taxes, and the note interest (at required IRS interest rates) payable to the grantor from the trust is not subject to income tax. The transaction is treated as a sale by the grantor to him or herself. Rev. Rul. 85-13, 1985-1 CB 484; PLR 9535026. Appreciation on the assets sold by the grantor to the trust grows outside the grantor’s estate. Hence the “freeze” works. If the grantor dies before the note is paid in full, only the unpaid balance of the note is included in the grantor’s estate. In appropriate cases, a SCIN may be considered for use in these circumstances to avoid any estate tax inclusion. Note that there is a carryover basis to the trust beneficiaries since the transaction is not treated as a sale. Consider appropriate valuation discounts here to “squeeze” the value of the transferred property to the trust, especially if the property is a minority interest in a corporation or an LLC or partnership. 4. The Seed Money Gift Requirement. The only gift tax element of this transaction arises from the requirement that the trust must be capitalized (“seeded”) with sufficient equity assets (other than the assets acquired from the grantor in exchange for the note) to establish the independence of the trust from the assets sold by the grantor to the trust. The capitalization is generally 10% of the value of the installment note to create a debt to equity ratio within the trust of 10:1. Other equity in the trust may arise by having the beneficiaries personally guarantee the installment note repayment to the grantor. With the increased gift tax exclusion, the amount of a seed money gift available to support an installment sale to a defective trust has increased dramatically. This suggests an aggressive use of this technique while the gift tax exclusion remains high, and the IDGT technique remains available. Where the grantor’s gift tax exclusion had already been used, and guarantees were installed to achieve the desired equity, those guarantees can now be withdrawn, if that is an appropriate step in light of all of the trust’s circumstances.

5. Have the Grantor Pay the Income Tax. Significantly, the trust grantor may pay the income tax on the trust’s income from

the grantor’s own funds without having such payment be characterized as a gift to the trust beneficiaries. This allows the grantor to further reduce his/her estate by making the income tax payments with no transfer tax consequences. (This is sometimes referred to as the “tax burn”). If the trust requires reimbursement to the grantor of income taxes paid, it will be viewed as a “retained interest” and all of the property contained in the trust will be included in the grantor’s estate. Giving an independent trustee discretion to reimburse the grantor for income taxes paid will not cause inclusion of the trust property in the grantor’s estate. Rev. Rul. 2004-64, 2004-2 CB 7.

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6. Administration Proposals to Eliminate the IDGT Planning Technique

The Obama Administration 2014 Budget includes a proposal which would eliminate the traditional estate tax benefits associated with installment sales to grantor trusts. If the grantor engages in a sale, exchange or comparable transaction with a "grantor trust" then the portion of the trust attributable to the property received by the trust in that transaction (including all retained income therefrom, appreciation thereon and reinvestments thereof, net of the amount of the consideration received in that transaction) would be subject to estate tax at the grantor's death. Termination of grantor trust status and distributions from the trust would be subject to gift tax. Transactions occurring before the enactment date would be grandfathered.

D. Transferring Wealth with Potentially No Gift Tax Cost: Using the GRAT 1. What Is a GRAT? For clients who are healthy - and willing to transfer property, but still require an income stream from that property, or want to exercise control over the property, an ideal planning solution for persons fitting this profile is the creation of a Grantor Retained Annuity Trust (GRAT). The GRAT is an irrevocable trust to which the trust grantor transfers property (securities, real estate, a family business, S corporation shares, etc. – discounted where appropriate) while retaining the right to receive an annuity interest, i.e. a fixed percentage return from the transferred property for a fixed term of years (a “qualified interest” within Code Section 2702). When the term of years expires, the property passes to the designated remainder beneficiaries of the trust (presumably the children of the grantor).

2. How a GRAT Works. The advantage of GRATs is the ability of the grantor to transfer property to the

remainder beneficiaries at a significantly reduced gift tax cost, since the actuarial value of the grantor’s retained interest is subtracted from the fair market value of the trust property to determine the gift tax value of the transfer. The larger the retained interest (based on the grantor’s age, duration of the trust, prevailing interest rates, and the selected fixed percentage retained payment) the smaller the taxable gift of the remainder interest.

3. The Zero- Gift Walton GRAT. a. The case of Walton v. Commissioner, 115 TC 589 (2000), acq.

Notice 2003-72, 2003-44 IRB 964 approved a “zeroed out GRAT” (i.e. a GRAT which provides a combination of a retained interest term and/or a substantial payout to the grantor or the grantor’s estate so as to result in no gift to the remainder beneficiaries). The IRS has issued Regulations approving the Walton GRAT. Reg. 25.2702-3(e), Examples 5 and 6. . Transferring property to a Walton GRAT allows the funding of the GRAT with no gift tax requirement. Since the annuity value of the GRAT is equal to the

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entire value of the transfers to the trust – plus the “hurdle rate” described below, the goal for planning success is appreciation.

b. If the value of the trust property appreciates at a rate greater than

the Code Section 7520 rate (which is required to be used as part of the actuarial calculation to determine the value of the annuity interest on the date of funding of the trust – this is sometimes referred to as the “hurdle rate”), the Walton GRAT will be a success - provided the grantor survives until the end of the trust term. If the grantor fails to survive the term, the grantor has retained an interest in the trust property at death, and an amount of the trust property valued as of the grantor’s date of death needed to provide the required annuity is included in the grantor’s estate. Reg. 20.2036-1. 4. Planning with Walton GRATs. a. Walton GRATs are generally designed to be of short duration (generally two years) with high annual payouts. Such short-term GRATs reduce the mortality risk. When the GRAT term ends, if the grantor is still alive and the property has appreciated, such appreciation passes tax free to the trust beneficiaries. Then, the process begins again for another short duration trust. This is referred to as “GRAT and re-GRAT”, or using “rollover GRATs”. b. Disadvantages of the short-term GRATs include concerns over rising interest rates. As rates increase, GRATs created in subsequent years under higher Section 7520 rates will demand grater annuity payments to the grantor, requiring more appreciation to provide a benefit to the trust beneficiaries. When rates are low, the temptation is to lock in to a longer-term GRAT. In evaluating the desirability of a Walton GRAT, planners should consider the “upside” of possibly moving appreciation out of a client’s estate at no transfer tax cost. c. If the GRAT “fails”, the grantor is exactly where he or she began - with the exception of the payment of professional and appraisal fees for creating the arrangement. 5. Proposed Anti-GRAT Legislation. The Administration’s 2014 budget has proposed limiting the use of GRATs by imposing the following requirements:

a. A minimum 10-year term. b. A remainder interest that is greater than zero (how much greater is not specified; commentators have suggested 10% is the likely target). c. No declining annuity during the first 10 years of the GRAT’s term.

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6. Single Property GRATs. In designing a GRAT, use several single property GRATs rather than diversified property GRATs, since the single property GRATs that “succeed” by appreciating will be beneficial, while the single property GRATs that “fail” to appreciate will not be harmful. A diversified GRAT that nets no gain or loss will not be beneficial. 7. Longer-Term GRATs May Be Favored with Low Interest Rates. Not all GRATs have to be zeroed out Walton GRATs. Where a client desires a longer term GRAT with a more modest annual annuity payment (5% is the lowest annual return permitted) a more “traditional” GRAT can be structured, which will bear some gift tax consequences, along with the greater mortality risk to avoid estate tax inclusion. The longer-term GRAT gives the property funding it more time to appreciate than is the case with the short-term Walton GRAT. If considering a longer term taxable GRAT, the grantor may want to “hedge” life expectancy by using a series of trusts of differing durations, or purchase a term life insurance policy with a premium guaranteed for the duration of the GRAT transaction. 8. Summary of GRAT Advantages and Rules. If the grantor survives the end of the trust term, the property has been removed from the grantor’s estate at a reduced transfer tax cost (note that a transfer to a GRAT is the gift of a future interest, ineligible for the present interest annual gift tax exclusion), and all of the post-date of gift appreciation inures to the benefit of the trust beneficiaries (note that if a GRAT “works” the grantor’s tax basis carries over to the beneficiaries, while if the GRAT is unsuccessful, and the property required to produce the annuity is included in the grantor’s taxable estate, the beneficiaries receive a basis equal to the property’s date of death value). Code Sections 1014, 1015. E. Leveraging the Transfer of a Personal Residence by Using a Qualified Personal Residence Trust.

1. Personal Residence. The transfer of a property used as a personal residence (it need not be the

grantor’s principal residence) to a trust in which the grantor retains the right to use and occupy such residence for a fixed number of years, with the remainder interest passing to children or other beneficiaries, offers significant transfer tax planning opportunities. 2. QPRT Summary. Where the grantor satisfies the criteria for the creation of a qualified personal residence trust (a “QPRT”) as set forth in Reg. 25.2702-5(c), the grantor is able to transfer the residence to a trust for the benefit of family members, only bearing a transfer tax cost equal to the present value of the remainder interest in the trust. The grantor

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maintains control, use and enjoyment of the residence during the trust term. If the grantor outlives the trust term, the residence is removed from the grantor’s estate, and all post-transfer appreciation inures to the benefit of the remainder beneficiaries. If the grantor dies before the end of the trust term, the residence is included in the grantor’s estate at its fair market value at death. 3. Gift Tax Advantages. The QPRT gift calculation results in a heavy weighting of the client’s retained interest and a generally favorable gift tax result. For clients with lifetime gift tax exemption available, the QPRT is a worthwhile use of that exemption. With the dramatic increase in the gift tax exemption under ATRA, the QPRT should be a popular planning technique. The QPRT is particularly popular where the family enjoys a grantor-owned vacation home. 4. Sale of the Residence. If the residence is sold during the QPRT term, and if it has been the client’s principal residence, it is eligible for the capital gain exclusion of $250,000 ($500,000 if the client files a joint return). Moreover, sale proceeds for the home may be reinvested in another personal residence (within two years of the sale of the original residence) without jeopardizing the QPRT arrangement. Alternatively, absent the purchase of another residence, the sale proceeds can be converted to a GRAT (with no further gift tax considerations) for the duration of the original QPRT term with no loss of the tax planning benefits.

5. Tenancy in Common Discount. Married persons owning a residence jointly should first transfer the residence to

themselves as tenants in common, each with an undivided 50% interest in the property, then have each spouse create his or her own QPRT. This will enable each of the spouses to claim a valuation discount (a recent Tax Court case, Ludwick v. Commissioner, TC Memo 2010-104, allowed a 17% discount) before making the QPRT calculation, thereby lowering the valuation of the property and decreasing the taxable gift.

6. Interest Rate Environment. While the QPRT is less attractive in a low interest rate environment, the

opportunity to combine declining property values and the favorable calculation of the QPRT remainder interest, especially for someone over age 65, still recommends the QPRT technique.

F. The Common Law GRIT Is Still Available to Certain Taxpayers. 1. Section 2702 Does Not Occupy the Entire Field

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a. The enactment of Code Section 2702 in 1990 directed most planning in the areas of personal residence trusts, qualified annuity interests and qualified unitrust interests, with all of their associated technical requirements and planning opportunities.

b. However, Code Section 2702 does not apply to all transactions. The so-called “common law GRIT” (Grantor Retained Interest Trust) remains a viable tax planning option in the appropriate circumstances. Its use was not foreclosed by Code Section 2702. 2. Use of the Common Law GRIT

a. If an individual does not have children and wishes to benefit relatives who are nieces and nephews- or persons who are “significant others”, the individual is outside of Code Section 2702 and the tax advantages of a GRIT are available. Note that after the Windsor decision, GRITs are no longer available to legally married same-sex couples. b. Section 2702 covers the transferor and “members of the transferor’s family.”

c. Nieces and nephews (as well as cousins and other collateral relatives and persons not considered “related” in the eyes of the federal law) are not covered by the term “members of the family”. Hence a common law GRIT can be created for them. 3. No Requirement of a “Qualified Interest” A trust can be created by the grantor with a retained income interest. The income interest need not be “qualified” within the meaning of Code Section 2702. The retained income interest is valued by standard actuarial rules, and the remainder interest constitutes a taxable gift. There is no minimum income or term requirement. In the “typical” GRIT, the grantor retains a right to all of the trust income for a term of years. The remainder is payable to a beneficiary falling outside the statutory definition of a “member of the family”. Code Section 2702(a)(2)(A). 4. Life and Death of the Grantor

If the grantor’s retained interest is for a period of years, and the grantor outlives the term, the property is out of the grantor’s estate. If the grantor dies within the term, the date of death value of the property is in the grantor’s estate. Where the grantor has retained the entire income interest in the trust, this is a retained use of the entire trust; accordingly, the full fair market value of the trust property at the grantor’s death will be included in the grantor’s estate. Reg. 20.2036-1. 5. GRIT Distributions, Investments and Powers

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a. Since Code Section 2702 does not apply in this situation, there is no obligation to distribute any principal to the grantor to satisfy an income obligation. Accordingly, the trust property can be invested in low yield, high growth assets which will inure entirely to the benefit of the remainder beneficiaries, so long as the grantor survives the retained interest term.

b. Moreover, since Code Section 2702 is not applicable, the common law GRIT may contain a commutation power whereby the grantor may be paid off at any time for his or her remaining actuarial interest in the trust. Therefore, if the grantor becomes ill, or something happens to suggest that the grantor will not survive until the end of the designated term, the commutation power can be used to make certain that the value of the underlying trust property will be excluded from the grantor’s estate. XI. Multi - Generation-Skipping Transfer Tax Planning: Using Dynasty Trusts A. The GST tax exemption may be used affirmatively to create a Dynasty

Trust. B. In general description, a Dynasty Trust provides for life estates in property

for every generation of beneficiaries. While the trustee is given the power to distribute trust principal, such distributions are discouraged.

C. A Dynasty Trust is typically structured to last for the maximum period of

time permitted by state law (i.e. the time period allowed by the rule against perpetuities). In some states the maximum duration of a trust is lives in being on the date of the creation of the trust plus 21 years. Other states have abolished the rule against perpetuities and provide that the trust may exist forever. Obviously, those states allowing the longest duration of the trust are the favored jurisdictions.

D. If a Dynasty Trust is created in a state that has abolished the rule against

perpetuities, and funded with an amount equal to the maximum available GST tax exemption of the transferor, the trust property will not be subjected to any further estate, gift or GST tax liabilities (assuming the trust principal is not distributed to the beneficiaries).

E. If an annual rate of growth of 7.2% is assumed for the trust principal, it

will double in value every ten years. Hence, the “Dynasty” is created by a transferor using his or her GST tax exemption for generations yet unborn.

F. Ideally, any use of GST tax exemption should be leveraged by funding a

generation-skipping transfer with property likely to appreciate in value over time. A lifetime gift might ideally address this suggestion. Given the $5,250,000 lifetime gift tax exemption available in 2013, this may be an ideal time to consider the Dynasty Trust planning opportunity.

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G. The Dynasty Trust offers the additional attraction of asset protection for

future generations, since no beneficiary of the trust is the “owner” of any of the trust assets, so that creditors of beneficiaries will be unable to reach such assets.

H. Proposed legislation in the Obama Administration 2014 Budget suggests

limiting the duration of the Dynasty Trust to a 90-year life, after which time the trust property would be required to be distributed to the trust beneficiaries and ultimately subjected to transfer taxation.

XII. ADDITIONAL 2014 FISCAL YEAR BUDGET PROPOSALS

In addition to the 2014 Budget proposals referred to above, on April 10, 2013, with the release of the Obama Administration's 2014 fiscal year budget proposals, together with the "General Explanations of the Administration's Fiscal Year 2014 Revenue Proposals," commonly referred to as the "Green Book," the permanency of the estate, gift and generation-skipping transfer tax law has again been questioned. There were a few short months of calm following the January 2, 2013 enactment of the American Taxpayer Relief Act of 2012 (“ATRA”). Now, the Administration makes a number of proposals affecting estate, gift and generation-skipping transfer taxes, including:

Restoring the estate, gift and generation-skipping transfer tax rates and exclusion amounts to their 2009 levels beginning in 2018. The top tax rate would increase to 45% (it is currently 40%). The federal estate and generation-skipping transfer tax exclusions, which are currently $5.25 million ($5 million indexed annually for inflation), would be reduced to $3.5 million. The gift tax exclusion, which is currently $5.25 million ($5 million indexed annually for inflation) would be reduced to $1 million. There would be no indexing of the exclusion for inflation in any case. Portability of the unused exclusion between spouses would remain.

Mandatory five-year rule for distribution of retirement plan assets to non-spouse beneficiaries. Retirement accounts would be required to be emptied by the end of the fifth year following the year of the plan participant’s death. The only allowable exceptions would be for transfers to surviving spouses, minor and disabled children. If enacted, this proposal would end stretch-out IRA planning for adult children and grandchildren. It would limit the attractiveness of using retirement trusts as estate planning vehicles, and reduce the value of Roth IRA

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conversions if rapid withdrawal is extended to all retirement plans, including Roth IRAs.