Tools of the Trade - Estate Planning Council (B0519491).DOC

TOOLS OF THE TRADE — Estate and Gift Techniques Following Recent (and Possible) Law Changes Estate Planning Council Birmingham, Alabama January 3, 2012 C Fred Daniels (205) 716-5232 cfd@cabaniss.com Leonard Wertheimer (205) 716-5254 lw@cabaniss.com Anna F Buckner (205) 716-5245 afb@cabaniss.com Cabaniss, Johnston, Gardner, Dumas & O’Neal LLP 2001 Park Place North, Suite 700 Birmingham, Alabama 35203 {B0519491.1} SPEAKERS LEONARD WERTHEIMER, III — Leonard Wertheimer is a partner in the Birmingham, Alabama office of Cabaniss, Johnston, Gardner, Dumas, & O’Neal LLP, where his practice is concentrated in the areas of estates and trusts, tax litigation, and closely-held businesses He received his B.S degree from the University of Virginia and his J.D degree from the Emory University School of Law Mr Wertheimer is a Fellow in the American College of Trust and Estate Counsel and is a Member of the Alabama Law Institute He was a member of the Alabama Law Institute committees that revised Alabama’s Probate Code, Principal and Income Act (chairman) Estate Tax Apportionment Act (chairman), Trust Code and Power of Attorney Act Mr Wertheimer is currently serving as chairman of the Alabama Law Institute committee preparing legislation to authorize the use of unitrusts In addition to being listed in Best Lawyers since 1987 in the field of Trusts and Estates he was named by Alabama Super Lawyers magazine as one of the best attorneys in Alabama in Trusts and Estates and has a Preeminent AV rating with Martindale Hubbell Mr Wertheimer is a frequent speaker at professional seminars presenting topics relating to estate planning, estate administration, business succession planning, generation-skipping tax planning and distributions from IRAs and qualified plans Mr Wertheimer is a former Adjunct Professor of the Masters in Tax Accounting Program at the University of Alabama School of Business as well as a former Adjunct Professor of the Birmingham Southern College School of Business ANNA FUNDERBURK BUCKNER — Anna Buckner is a partner in the Birmingham, Alabama office of Cabaniss, Johnston, Gardner, Dumas & O’Neal LLP, where she practices in the areas of estates and trusts, including estate planning and administration, taxation, real estate and corporate law A former professional tennis player, Mrs Buckner attended Auburn University (B.S., cum laude, 1993; M.B.A., 1995) and Cumberland School of Law (J.D., magna cum laude, 1999) Mrs Buckner is trained in Collaborative Practice She is a member of the International Academy of Collaborative Professionals (IACP), a consortium of lawyers, financial professionals and mental health professionals who are committed to helping resolve civil and domestic relations disputes in a collaborative manner outside traditional legal forums She is also a member of the Birmingham Collaborative Alliance, serving on the training committee For more information about this aspect of her practice, see www.collaborativepractice.com Mrs Buckner is a licensed real estate agent, and a former member of the National Association of Realtors and the Birmingham Association of Realtors She is a member of the Alabama, Birmingham and American Bar Associations and participates in the Sections on Business Law, Taxation, and Real Property, Probate and Trust Law Mrs Buckner currently serves on the Board for the Make-A-Wish Foundation of Alabama and she also served on the Cumberland School of Law Annual Fund Committee and is a member of the Kiwanis Club of Birmingham She served on the Board of Directors for the Auburn University Bar Association and was a {B0519491.1} member of the Charter Class of the Alabama State Bar Leadership Forum in 2005 She has also been an adjunct professor at Cumberland School of Law teaching Real Estate Transactions Mrs Buckner is a member of the Birmingham Estate Planning Counsel and the Alabama and National Associations for Charitable Planned Giving She is a member of the Alabama Law Institute where she was a member of the committees that revised the Alabama Prudent Investor Act, the Alabama Uniform Trust Code, the Uniform Prudent Management of Institutional Funds Act, and the Alabama Durable Power of Attorney Act She currently serves on the Alabama Law Institute Unitrust Act Committee and is an Alabama Law Institute Counsel Member Mrs Buckner frequently lectures on estate planning topics locally and regionally She serves on the Board of Trustees of the American Institute on Federal Taxation and is a Fellow in the American College of Trust and Estate Counsel (ACTEC) where she also serves on the Fiduciary Litigation Committee {B0519491.1} Table of Contents Page I INTRODUCTION -1A Where Are We and How Did We Get Here? -1B Planning Prior to TRUIRA 2010 -3- II PORTABILITY; GREAT FOR CLIENTS, DANGER FOR ADVISORS -5A Doubling of the Applicable Exclusion Amount -5B Calculation of DSUEA -6C Estate Tax Return Requirement -8D Serial Spouses - 10 E DSUEA Tax Audits - 11 F Traps for the Unwary - 12 G Continued Desirability of Credit Shelter Trusts - 13 H Clauses Concerning the Filing of Estate Tax Returns - 14 - III DISCLAIMER TRUSTS - 16 A Sample Language - 16 B Some Circumstances that Suggest the Use of Disclaimer Trusts (i) {B0519491.1} C - 17 Pitfalls - 17 - IV TOTAL RETURN TRUSTS - 18 A Total Return Trust Structure - 18 B Additional Features and Considerations - 18 C Marital Deduction Trusts - 19 - V FORMULA ALLOCATION AND WANDRY DEFINED VALUE CLAUSES - 20 A Formula Allocation Clauses - 20 B Wandry or Formula Transfer Clauses - 21 C The Proctor Issue - 22 D Planning - 23 - VI NINETY-NINE YEAR GRATs - 23 A Traditional GRAT Planning - 23 B Extremely Long-Term GRATs - 24 C Operation of the GRAT Following the Grantor’s Death - 26 D Payment of Estate Taxes (ii) {B0519491.1} E F - 28 Payment of the Grantor’s Income Taxes - 29 Legislative Concerns - 30 - VII SPOUSAL LIMITED ACCESS TRUSTS - 31 A The Reciprocal Trust Doctrine - 31 B The Levy Case - 31 C Non-Reciprocal Trust Strategies - 32 D Exercise of Power of Appointment in Favor of the Donor Spouse - 33 - VIII CLAWBACKS - 35 - IX GIFTS TO PARENT’S TRUSTS - 35 A Structure of the Trust - 35 B Tax Effect of the Gifts - 36 - X SM SUPERCHARGED CREDIT SHELTER TRUSTS - 37 A Structure of the Supercharged Credit Shelter Trust SM B - 37 Grantor Trust Treatment for the Credit Shelter Trust (iii) {B0519491.1} C D XI - 39 Effect of Creditor Rights - 39 Income Tax Basis Following Death of First Spousal Beneficiary - 40 - PLANNING FOR THE CREDIT FOR TAX ON PRIOR TRANSFERS - 41 A Property not Included in Second Decedent’ Estate - 41 B Application to Life Interests - 42 C Percentage Limitations - 43 D Limitations Based Upon Amount of Tax - 43 - (iv) {B0519491.1} TOOLS OF THE TRADE — Estate and Gift Techniques Following Recent (and Possible) Law Changes C Fred Daniels * Presented by Leonard Wertheimer and Anna F Buckner I INTRODUCTION The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (“TRUIRA 2010”) increased the estate tax exclusion amount to $5,000,000 for decedents dying in 2011 and 2012 and indexed it for inflation There is a possibility that the $5,000,000 applicable exclusion amount might continue after 2012 It is not likely that it will be reduced below $3,500,000, although a failure by Congress to act will result in a $1,000,000 applicable exclusion amount A Where Are We and How Did We Get Here? It is often perceived that only in the last decade has the estate tax been constantly changing As indicated in the table below, there have only been two periods when there was not constant change — 1948 to 1976 and 1987 to 1997 Year 1916 1917 1918–23 1923–25 1924 * Excluded Amount $50,000 $50,000 $50,000 $50,000 Rates 1% to 10% 2% to 25% 1% to 25% 1% to 40% Gift tax added Unless otherwise indicated— Section references refer to the Internal Revenue Code of 1986, as amended; and Regulation references refer to sections of the Treasury Regulations The reader is cautioned that there can be uncertainty in the interpretation and application of tax and other law, and much of what is expressed herein is the opinion of the author and others The reader must make an independent determination as to the proper interpretation and application of tax and other law to the matters discussed herein The reader is further cautioned not to rely on forms and clauses in these materials “as is” but to determine independently the appropriateness of each form and clause together with its compliance with applicable law {B0519491.1} B 1926–31 1932–33 1934 1935–39 1940 1941 1942–76 1948 1977 $100,000 $50,000 $50,000 $40,000 $40,000 $40,000 $60,000 1978 1979 1980 1981 1982 $134,000 $147,000 $161,000 $175,000 $225,000 1983 1984 1985 1986 $275,000 $325,000 $400,000 $500,000 1987–97 1987 1998 1999 2000–01 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 $600,000 1% to 20% 1% to 45% 1% to 60% 2% to 70% 2% to 70% plus 10% surtax 3% to 77% 3% to 77% 50% marital deduction enacted 18% to 70% Gift and estate tax unified Minimum marital deduction of $250,000 18% to 70% 18% to 70% 18% to 70% 18% to 70% 18% to 65% unlimited marital deduction Qualified disclaimers authorized 18% to 60% 18% to 55% 18% to 55% 18% to 55% GST enacted 37% to 55% 5% surtax over $10,000,000 37% to 55% 37% to 55% 37% to 55% 41% to 50% 41% to 49% 45% to 48% 18% to 47% 46% 45% 45% 45% 35% or no tax if elected 35% 35% $120,000 $625,000 $650,000 $675,000 $1,000,000 $1,000,000 $1,500,000 $1,500,000 $2,000,000 $2,000,000 $2,000,000 $3,500,000 $5,000,000 $5,000,000 $5,120,000 Planning Prior to TRUIRA 2010 Marital Formula Wills The 50% marital deduction was added to the estate tax law in 1948 for non-community property, and it led to {B0519491.1} marital formula wills for couples whose combined net worth exceeded what was then $60,000.00 exemption from estate tax (a) Formulas Prior to 1977 From 1948 until 1977, the basic marital formula was to give 50% of the so-called adjusted taxable estate to what is now called a credit shelter trust and to give the remainder outright to the spouse or to a marital deduction trust that included a general power of appointment.2 This practice created the need to equalize a husband’s and wife’s separate estates, but equalization often involved gift tax consequences because the gift tax marital deduction was only 50%, not unlimited (b) Formulas from 1977 to 1981 The 1976 Tax Reform Act increased the marital deduction to the greater of $250,000 or 50% Marital formulas were modified accordingly (c) Formulas after the Unlimited Marital Deduction The Economic Recovery Act of 1981 added the unlimited marital deduction effective 1982, and the formula changed dramatically The predominant formula allocated the maximum exempt amount to the credit shelter trust and the balance, if any to the surviving spouse QTIP Trusts The Economic Recovery Tax Act of 1981 extended the marital deduction to qualified terminal interest property (“QTIP”) Thereafter, martial trusts tended to be in the form of QTIP trusts instead of pay-all-income trusts coupled with a general power of appointment Lifetime Gifts and Unification There was an independent gift tax until 1977 that had a $30,000.00 lifetime exclusion and rates that were three-fourths of the estate tax rates This resulted in an incentive to use the lifetime exclusion rather than lose it and also to take advantage of the lower gift tax rates The 1976 Tax Reform Act The theory of the 50% marital deduction was to give decedents in common law states the same tax advantage that was attained in community property states Joint income tax returns were added at the same time for the same reason Without these changes, the tax laws were an incentive for common law states to change to community property, and many did Qualified terminal interest property (“QTIP”) trusts were not available until 1982 {B0519491.1} receive annual annuity payments, they typically will be less than the tax distributions Distributions from the GRAT to Pay Income Taxes Rev Rul 2004-64; 2004-2 C.B address tax consequences of a grantor trust’s payment of the income tax attributable to the inclusion of the trust’s income in the grantor’s taxable income (a) No Taxable Gift The IRS confirmed in the ruling that the grantor’s payment of the income taxes is not a taxable gift (b) Estate Taxes If the trust’s governing instrument or local law gives the trustee the discretion to reimburse the grantor for the grantor’s income tax liability, that discretion, by itself, does not cause the trust’s assets to be includable in the grantor’s gross estate However, the full value of the trust’s assets is includable in the grantor’s gross estate if the trust’s governing instrument or local law requires the trust to reimburse the grantor for the income tax attributable to the trust’s income § 2036(a)(1); Rev Rul 2004-64, 2004-2 C.B (c) Possible Need for Independent Trustee The facts in Rev Rul 2004-64 state that the governing instrument required that the trustee be a person not related or subordinate to the grantor within the meaning of § 672(c) It also qualified its holding regarding estate tax exclusion by stating that a power retained by the grantor to remove the trustee and name the grantor as successor trustee could result in estate tax inclusion Note however, that a child who is the beneficiary of the trust is an adverse party as defined in § 672(a) and, therefore, is not related or subordinate to the grantor within the meaning of § 672(c) (d) Sample Language The following is a clause that might be used for this purpose: Distributions to Satisfy My Personal Income Tax Liability At any time (i) that the Trustee is a person who is not related or subordinate to me within the meaning of § 672(c) of the Internal Revenue Code and (ii) that I am treated as the owner of any portion of any trust hereunder pursuant to the provisions of subpart E of part I of subchapter J of chapter 29 {B0519491.1} of subtitle A of the Internal Revenue Code for the taxable year, the Trustee may, in the Trustee’s discretion, distribute to me for the taxable year income or principal sufficient to satisfy my personal income tax liability attributable to the inclusion of all or part of the trust's income in my taxable income If (i) more than one person is serving as Trustee and (ii) one or more of the Trustees is related or subordinate to me within the meaning of § 672(c) of the Internal Revenue Code but (iii) one or more is not so related or subordinate, the foregoing power may be exercised by a majority of the Trustees who are not related or subordinate to me within the meaning of § 672(c) of the Internal Revenue Code It my intention that this power be consistent with the provisions of Situation of Revenue Ruling 2004-64; 2004-2 C.B 7, and I direct that it be interpreted, administered and applied in accordance therewith, it being my overriding intention that this provision not cause the inclusion of the trust in my gross estate for federal estate tax purposes I reserve the right to release this power at any time F Purchase of Assets from the Grantor To the extent the GRAT receives distributions that exceed the amount needed to pay the annuity payments, the excess funds can be used to purchase other assets from the grantor By making the GRAT into a grantor trust, the purchase from the grantor will be a non-event for income tax purposes Legislative Concerns The Treasury’s 2012 estate tax proposals include limiting GRATs to terms no shorter than 10 years and no longer than the grantor’s life expectancy plus 10 years VII SPOUSAL LIMITED ACCESS TRUSTS A couple may want to use their $5,120,000.00 applicable exclusion amounts during 2012 but retain access to the gifted assets One way to this is for the husband to create a $5,120,000.00 trust (a “SLAT”) for the wife and for the wife to create a $5,120,000.00 trust for the husband If so, the reciprocal trust doctrine might undermine the effectiveness of the gifts 30 {B0519491.1} A The Reciprocal Trust Doctrine United States v Estate of Grace, 395 U.S 316 (1969), involve a husband who created a trust that provide income to his wife for life followed by a similar trust created by the wife fifteen days later The Supreme Court held that the trust created for the husband by the wife should be included in the husband’s gross estate under an earlier version of § 2036 because the trusts were identical and created essentially at the same time Under the Court’s theory, the husband essentially was the grantor of the trust nominally created by the wife Under § 2036(a)(1), a trust is included in a grantor’s estate if the grantor retained the right to the income for life For a further discussion of Grace and the reciprocal trust doctrine, see G Slade, THE EVOLUTION OF THE RECIPROCAL TRUST DOCTRINE SINCE GRACE AND ITS CURRENT APPLICATION IN ESTATE PLANNING, 17 Tax Mgmt Est Gifts & Tr J 71 (1992) B The Levy Case The Tax Court revisited the reciprocal trust doctrine in Levy v Comm’r, 46 T.C.M (CCH) 910 (1983) There, a husband and wife created trusts on the same day that gave each other an income interest The trusts were not identical because one of them provided its spousal beneficiary a limited power of appointment to its spousal beneficiary, and the other trust did not Importance of Different Provisions In determining that the reciprocal trust doctrine did not apply due to this difference, the court referenced the following language from Grace: The reciprocal trust doctrine does not purport to reach transfers in trust which create different interests and which change “the effective position of each party vis a vis the [transferred] property ” C The IRS Concession Significantly, the IRS conceded in Levy that the wife’s limited power of appointment in the wife, if valid, prevented the two trusts from being interrelated and, therefore, subject to the reciprocal trust doctrine Although it is not precedential, the IRS has embraced Levy See PLR 200426008 Non-Reciprocal Trust Strategies Strategies to avoid the application of the reciprocal trust doctrine include the following: 31 {B0519491.1} Create at Different Times Create the trusts at different times separated by months, not days as in Grace Even if the terms of two trusts are identical, the reciprocal trust doctrine should still not apply if the trusts are not created in the same time frame See Grace, 395 U.S at 316 (emphasizing that the trusts were interrelated because of the parallel terms and because created within a 15-day period) Different Limited Powers of Appointments As in Levy, one trust might contain a limited power of appointment while the other would not In the alternative, both trusts might have limited powers of appointment but exercisable in favor of different classes of appointees and, perhaps, might be exercisable only with the consent of a non-adverse party) Different Distribution Directions One trust might be a pay all income or pay a unitrust amount for a spouse and the other might be a sprinkle trust for the other spouse and their descendants Discretionary Tax Reimbursement Clause One trust might have a Rev Rul 2004-64; 2004-2 C.B discretionary tax reimbursement clause with respect to satisfy its grantor’s personal income tax liability attributable to the inclusion of all or part of the trust's income in the grantor’s taxable income Different Trustees The trusts might have significantly different trustees, such as a bank trustee for one and individual trustee for the other Trustee Portability The trusts might have different portability provisions for changing trustees In the alternative, one might have provisions to change trustees and the other might not have such provisions Different Powers of Principal Invasion One trust might provide that other resources of the spouse beneficiary should be taken into account when invade principal and the other might direct that the existence of other resources is irrelevant Fund with Different Assets The trusts might be funded with different assets and with different values For example, one trust might be funded with real estate or a closely held business interest, and the other might be funded with marketable securities and cash 32 {B0519491.1} D Exercise of Power of Appointment in Favor of the Donor Spouse Although distributions from the trusts are available for the family through distributions from each trust to its respective spousal beneficiary, the inclusion of a provision to provide benefits to the donor spouse following the death of the beneficiary spouse will result in inclusion of the trust in the donor spouse’s estate as a § 2036 retained life estate or a § 2038 revocable transfer However, there should be no inclusion if the donee spouse exercises a power of appointment at a later date to create a successive trust for the donor spouse, unless the exercise of the power of appointment was pursuant to a pre-existing agreement or plan to so The analysis is as follows: Section 2036 Section 2036 only applies to transfers where the decedent retains the prohibited interest See, e.g., United States v O’Malley, 383 U.S 627 (1966) Section 2036(a) provides as follows: Sec 2036 Transfers with retained life estate (a) General rule The value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in case of a bona fide sale for an adequate and full consideration in money or money’s worth), by trust or otherwise, under which he has retained for his life or for any period not ascertainable without reference to his death or for any period which does not in fact end before his death— (1) the possession or enjoyment of, or the right to the income from, the property, or (2) the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom By not including provisions for the benefit of the grantor spouse, there will be no retention even if the first beneficiary spouse adds provisions at a later date 33 {B0519491.1} Section 2038 Section 2038 is not limited to a retained right, but instead, it applies to certain powers “without regard to when or from what source the decedent acquired such power.” It states Sec 2038 Revocable transfers (a) In general The value of the gross estate shall include the value of all property (1) Transfers after June 22, 1936 To the extent of any interest therein of which the decedent has at any time made a transfer (except in case of a bona fide sale for an adequate and full consideration in money or money’s worth), by trust or otherwise, where the enjoyment thereof was subject at the date of his death to any change through the exercise of a power (in whatever capacity exercisable) by the decedent alone or by the decedent in conjunction with any other person (without regard to when or from what source the decedent acquired such power), to alter, amend, revoke, or terminate, or where any such power is relinquished during the year period ending on the date of the decedent’s death The interpretation of § 2038(a)(1) is that it is directed at situations where the transferor-decedent set the machinery in motion that purposefully allows fiduciary powers over the property interest to subsequently return to the transferor-decedent Estate of Skifter v Comm’r, 468 F.2d 699 (2d Cir 1972); Estate of Reed v United States, Civil No 74-543 (M.D Fla., May 7, 1975); Rev Rul 84-179, 1984-2 C.B 195 Absent a pre-agreed plan for the first beneficiary spouse to exercise the power of appointment in favor of the grantor spouse, § 2038(a)(1) should not apply VIII CLAWBACKS No gift tax will be owed if a taxpayer who has not made prior taxable gifts makes a $5,120,000.00 taxable gift during 2012 There is uncertainty as to what happens, however, when the taxpayer dies if the applicable credit amount is reduced to 34 {B0519491.1} $3,500,000.00 or $1,000,000.00 for 2013 and later years As presently enacted, the savings is “clawed back” when the taxpayer dies However, the Treasury’s Green Book states that clawback was not intended, and this is expected to be clarified in future legislation In fact, Senate Majority Leader Harry Reid has proposed legislation to clarify that there is no clawback If so, a taxpayer can avoid transfer taxes on $1,620,000.00 or $4,120,000.00, as the case may be, by using the $5,120,000.00 applicable exclusion amount during 2012 IX GIFTS TO PARENT’S TRUSTS A wealthy taxpayer with one or both parents alive who not have substantial wealth (i.e., net worth less than their applicable exclusion amounts) can make $13,000.00 annual gifts ($14,000.00 beginning in 2014) in trust to take use the parents’ applicable exclusion amounts for the benefit of the wealthy taxpayer’s descendants A Structure of the Trust Typical provisions for a parent’s trust include the following: The parent is given a Crummey withdrawal right so that the gifts will qualify for the $13,000.00 annual gift exclusion for present interest gifts Distributions to the parent are limited to a narrow standard that takes into account other resources available to the party The expectation is that the trustee likely will never make any distribution to the parent The parent is given a narrow general power of appointment For example, the power of appointment might be limited to the creditors of the parent’s estate If difficulties later developed (e.g., the parent develops mild to moderate dementia or becomes under the influence of a person with improper motives), the parent will not be able to appoint the trust to a different individual Upon the parent’s death, the remainder of the trust will pass tax free (due to the small size of the parent’s estate) to the wealthy taxpayer’s descendants, usually in a generation-skipping trust The wealthy taxpayer will retain a right that results in a grantor trust, such as a § 675(4)(C) non-fiduciary power to reacquire the trust 35 {B0519491.1} corpus by substituting other property of an equivalent value This further leverages the transfer B Tax Effect of the Gifts The tax results of the parental trust typically are the following: X By using Crummey withdrawal rights and limiting each year’s gift to the $13,000.00 annual gift exclusion for present interest gifts, the additions to the parental trust not use any of the wealthy taxpayer’s gift tax exclusion amount, estate tax exclusion amount or generation-skipping transfer tax exemption By creating grantor trust status, the parent does not pay income tax on the trust’s taxable income The wealthy taxpayer’s payment of the income tax further enhances the transfer tax free growth of the trust, i.e., the assets that ultimately pass to the wealthy taxpayer’s descendants By giving the parent a general power of appointment, the trust assets will be included in the parent’s estate when he or she dies (a) If the parent’s net worth inclusive of the trust is still less than the parent’s estate tax applicable exclusion amounts, the trust assets will pass estate tax free to the wealthy taxpayer’s descendants or trusts for their benefit (b) If the parent’s net worth inclusive of the trust is still less than the parent’s remaining generation-skipping transfer tax exemption, the trust assets will pass free of the generationskipping transfer tax SUPERCHARGED CREDIT SHELTER TRUSTS SM The ultimate credit-shelter trust for a surviving spouse who has more than adequate wealth is one that does not make distributions to the spouse yet results in the surviving spouse bearing the income tax burden under the grantor trust rules 6 Mitchell M Gans, Jonathan G Blattmachr, and Diana S C Zeydel refer to this as a “Supercharged Credit Shelter TrustSM” Their excellent article on this topic is Mitchell M Gans, Jonathan G Blattmachr, and Diana S C Zeydel, SUPERCHARGED CREDIT SHELTER 36 {B0519491.1} The surviving spouse’s payment of the income tax permits the trust estate to grow income tax free Moreover, during the surviving spouse’s lifetime, income can be distributed to descendants without incurring gift tax if it is a sprinkle trust However, a credit-shelter trust created under the will of the first spouse to die cannot be a grantor trust for the surviving spouse because the surviving spouse is not the grantor “Supercharging” refers to a technique to create a credit-shelter trust that will be a grantor trust A Structure of the Supercharged Credit Shelter Trust SM The desired result can be achieved through the use of an inter vivos QTIP trust The technique is as follows: The grantor spouse creates an inter vivos QTIP trust for donee spouse (a) The grantor spouse is a spouse with substantial wealth The plan is structured on the assumption that the grantor spouse may be the second spouse to die and will become the beneficiary of a credit shelter trust (b) The donee spouse is the spouse who the plan assumes might be the first to die The trust is structured so that the donee spouse will be treated as creating the credit-shelter trust for estate tax purposes even though he or she is not the person who actually creates the trust The additional goal, however, is for the grantor spouse, instead of the donee spouse, to be treated as the grantor of the credit-shelter trust for income tax purposes The grantor will make a QTIP election when creating the trust for the donee spouse The election must be made on a timely filed gift tax return Late elections cannot be made TRUSTSM, 52 Probate & Property, July/August 2007 Most of the observations and suggestions in this section reflect ideas presented in their article as well as discussions with Mr Blattmachr “Supercharged Credit Shelter Trust SM” is a servicemark of Prof Gans, Mr Blattmachr, and Ms Zeydel, who have granted permission for it to be used without charge provided appropriate attribution is given to them for its use 37 {B0519491.1} As a QTIP trust, the trust qualifies for the gift tax marital deduction, and no gift tax is payable upon creation of the trust Also because of the QTIP election, the trust is included in the donee spouse’s gross estate if the donee spouse dies first § 2044 While both spouses are alive, the trust is deemed to be wholly owned by the grantor because a grantor is treated as holding all powers or interests held by his or her spouse § 671(e)(1) A grantor is deemed to own a trust where he or she has retained the right to the income and principal of the trust §§ 676 and 677 Therefore, all of the trust’s taxable income (whether allocated to accounting income or to principal) is taxed to the grantor spouse Assuming the donee spouse is the first to die, the inter vivos QTIP trust will provide that an amount equal to the donee spouse’s remaining applicable credit amount is left to a credit-shelter trust for the benefit of the grantor spouse The assets of the inter vivos QTIP trust are included in the donee spouse’s gross estate upon the donee spouse’s death § 2044 B (a) However, no estate tax is owed due to the donee spouse’s remaining applicable credit amount (b) Assets in excess of the donee spouse’s remaining applicable credit amount can be structured to pass to or for the benefit of the grantor spouse in a form that qualifies for the estate tax marital deduction If so, no estate tax is owed The credit shelter trust is not included in the grantor spouse’s gross estate Although § 2036 ordinarily includes trust assets in a grantor’s gross estate if the grantor is a beneficiary, the QTIP regulations prohibit the IRS from invoking § 2036 or § 2038 in the surviving spouse’s estate in the case of such a lifetime QTIP See Reg § 25.2523(f)-1(f), ex 11 Grantor Trust Treatment for the Credit Shelter Trust For income tax purposes, not estate tax purposes, the trust continues to be the grantor spouse’s grantor trust after the donee spouse’s death if the trustee has discretion to make distributions of income and principal to the grantor spouse See §§ 676 and 677 It does not matter that it was included 38 {B0519491.1} in the donee spouse’s gross estate under § 2044 for estate tax purposes See Reg § 1.671-2(e)(5) The regulation provides that, in the absence of someone exercising a general power of appointment over the trust, the original grantor’s status as the grantor continues C Effect of Creditor Rights In most, but not all, states, a grantor’s creditors can reach assets if the grantor is entitled or eligible in the discretion of a trustee to receive distributions from a trust that he or she has created See Restatement (3d) of Trusts §§ 57–60 The ability of a grantor’s creditors to reach trust assets typically results in inclusion of the trust in the gross estate under § 2036 See, e.g., Outwin v Comm’r, 76 T.C 153 (1981), acq 1981-2 C.B 1; Palozzi v Comm’r, 23 T.C 182 (1954), acq 1962-1 C.B 4; Estate of Paxton v Comm’r, 86 T.C 785 (1986); Rev Rul 77-378, 1977-2 C.B 348 Although the QTIP regulations preclude the IRS from invoking §§ 2036 and 2038 in this context, they not preclude the application of § 2041, which concerns powers of appointment See Reg § 25.2523(f)-1(f), ex 11 These leaves open the risk of inclusion in the grantor’s gross estate, and the plan should be structured so that § 2041 does not apply to the credit shelter trust created for the grantor spouse’s benefit out of the inter vivos QTIP trust he or she created for the first spousal beneficiary Use of Ascertainable Standards Section 2041 can be negated through the use of an ascertainable standard relating to health, education, maintenance, or support If distributions from the credit shelter trust to the grantor spouse are limited by an ascertainable standard, § 2041 will not apply even if creditors can access the trust’s assets under state law In states permitting creditors access, creditors are typically only able to reach the amount that the trustee could distribute to the grantor under a maximum exercise of discretion See, e.g., Vanderbilt Creditor Corp v Chase Manhattan Bank, NA, 473 N.Y.S.2d 242 (App Div 1984); comment f to Restatement (3d) of Trusts § 60 Because Code § 2041 excludes from the definition of a general power of appointment a right to property circumscribed by such a standard, including an appropriate standard would preclude the application of § 2041 Form Trust in an Asset Protection State The trust can be formed under the laws of a state that does not permit the grantor’s creditors to access trust assets (e.g., Alaska, Delaware, Nevada, Rhode Island, South Dakota, Utah, and, to a limited extent, Oklahoma) See, e.g., Estate of German v United States, Ct Cl 641 (1985) (no estate tax 39 {B0519491.1} inclusion in estate of grantor who was eligible to receive income and corpus from the trust because her creditors could not attach the trust property under the law under which the trust was created) D Income Tax Basis Following Death of First Spousal Beneficiary It is not clear whether the basis of the assets in the QTIP trust is stepped up at the death of the donee spouse The income tax basis of QTIP property included in a decedent’s estate under § 2044 is its estate tax value Section 1014(b)(10) provides the following in this regard: Sec 1014 Basis of property acquired from a decedent ***** (b) Property acquired from the decedent For purposes of subsection (a), the following property shall be considered to have been acquired from or to have passed from the decedent: ***** (10) Property includible in the gross estate of the decedent under section 2044 (relating to certain property for which marital deduction was previously allowed) In any such case, the last sentences of paragraph (9) shall apply as if such property were described in the first sentence of paragraph (9) Because the grantor spouse is the deemed owner of the trust’s assets before the death of the donee spouse and will be the deemed owner of the assets in the credit shelter trust, there may be a question whether the grantor-trust rules or the step-up-in basis rule of § 1014(b)(10) should govern due to a theory that the assets were owned by the grantor spouse at all times for income tax purposes It appears that the step up in basis rule should control because § 1014(b)(10), in providing for a basis adjustment in the case of all QTIPs, does not set forth an exception to the rule with regard to inter vivos QTIP trusts 40 {B0519491.1} XI PLANNING FOR THE CREDIT FOR TAX ON PRIOR TRANSFERS Before the unlimited marital deduction was added by the Economic Recovery Tax of 1981, estates of the first spouses to die routinely paid estate tax because the estate tax exemption was only $60,000.00 Because the surviving spouse most often died within ten years, the § 2013 credit for tax on prior transfers was used with regularity Although this has changed, there are still planning opportunities for the use of this credit A Property not Included in Second Decedent’ Estate There is a mistaken belief that the credit is not available unless the property from the prior decedent’s estate is included in the second decedent’s gross estate However, the regulations provided the following: Sec 20.2013-1 Credit for tax on prior transfers (a) In general A credit is allowed under section 2013 against the Federal estate tax imposed on the present decedent’s estate for Federal estate tax paid on the transfer of property to the present decedent from a transferor who died within ten years before, or within two years after, the present decedent’s death See section 20.2013-5 for definition of the terms “property” and “transfer” There is no requirement that the transferred property be identified in the estate of the present decedent or that the property be in existence at the time of the decedent’s death It is sufficient that the transfer of the property was subjected to Federal estate tax in the estate of the transferor and that the transferor died within the prescribed period of time (emphasis added) B Application to Life Interests Thus, a pay-all-income interest in a trust can trigger the credit for the surviving spouse’s estate even though the interest is excluded from the surviving spouse’s estate This can be achieved by using a pay-all-income credit shelter trust and a QTIP trust that does not make the QTIP election Example Assume the following facts: Jane died February 15, 2011 when her husband, George, was age 73, and her net estate was $7,500,000.00 $5,000,000.00 was left to 41 {B0519491.1} a-pay-all income credit-shelter trust for George The remaining $2,500,000.00 was left to a QTIP trust for George George died six months later on August 15, 2011 George’s gross estate is $7,500,000.00 not counting the $2,500,000.00 QTIP trust (a) Taxes if QTIP is Elected If Jane’s personal representation makes the QTIP election, the marital deduction will reduce her taxable estate to $5,000,000 and, after applying the applicable exclusion amount, her tax liability is zero George’s taxable estate will be the sum of his $7,500,000 in assets plus the $2,500,000 QTIP trust from Jane’s estate The estate tax at his death will be $1,750,000.00 (35% x ($10,000,000 – $5,000,000)) (b) Taxes if QTIP is Not Elected If the QTIP election is not made, Jane’s taxable estate is $7,500,000, and the estate tax at her death is $875,000.00 (($7,500,000.00 – $5,000,000) x 35%) (i) Because George’s estate does not include the QTIP trust, his taxable estate is $7,500,000, and his estate tax before the credit is also $875,000.00 (ii) However, the life interest factor for a 73 year old taxpayer during February, 2011 is 0.27513 Applied to $7,500,000 in pay-all-income trusts for George, the value of his life interest that was included in Jane’s gross estate before payment of Jane’s estate taxes is $2,063,475 However, $240,739 (27.513%) of Jane’s $875,000 in estates is charged to this interest, which leaves a net value of $1,822,736 ($2,063,475 – $240,739) (iii) This results in a credit against George’s estate tax for $237,042 in estate taxes paid by Jane with respect to the $2,063,475 life interest given to George Calculation of the credit is on the IRS Worksheet for Schedule Q and forms attached hereto as Appendix “B”) 42 {B0519491.1} C Planning The key to planning for use of the credit is to use pay-allincome trusts so that the life interest given to the surviving spouse is capable of valuation Percentage Limitations The credit is only available if the transferor decedent died no more than ten years before the present decedent or two years after the present decedent The credit is using the following table if the transferor decedent died more than two years before the present decedent 80% if the transferor died within the third or fourth years preceding the present decedent’s death 60% if the transferor died within the fifth or sixth years preceding the present decedent’s death 40% if the transferor died within the seventh or eighth years preceding the present decedent’s death 20 percent, if the transferor died within the ninth or tenth years preceding the present decedent’s death D Limitations Based Upon Amount of Tax The credit cannot exceed the lesser of (i) the Federal estate tax attributable to the transferred property in the transferor’s estate, or (ii) the Federal estate tax attributable to the transferred property in the decedent’s estate 43 {B0519491.1} ... before the death of the donee spouse and will be the deemed owner of the assets in the credit shelter trust, there may be a question whether the grantor-trust rules or the step-up-in basis rule of. .. to the end of the 99-year term, plans must be made for a source of payment of the estate taxes The GRAT is not the source to be used E Payment of the Grantor’s Income Taxes As with all GRATs, the. .. at the time of the decedent’s death It is sufficient that the transfer of the property was subjected to Federal estate tax in the estate of the transferor and that the transferor died within the