President Obama introduced his budget proposals on Valentine’s Day, and has dampened the enthusiasm for many changes and opportunities enacted in the Tax Relief Act of 2010 (TRA 2010).
Rates and Exemptions. TRA 2010 reduced the estate and gift tax rates to 35%, but the President would increase the rates back to 2009 levels, or 45%. TRA also increased the estate, generation skipping transfer (GST) tax, and gift tax lifetime exemptions to $5 million person, while the President would restore the 2009 estate tax and GST tax exemptions to $3.5 million and the gift tax exemption to $1 million. Remember, if Congress does nothing, the estate, GST tax and gift tax exemptions would drop back to $1 million (which has never happened in the history of this tax) and rates would jump to 55 percent.
Portability. TRA 2010 introduced – for the first time – the concept of “portability.” Stated simply, the new law allows a surviving spouse to inherit any portion of the deceased spouse’s unused estate tax exemption and tack it onto his or her exemption for purposes of minimizing exposure to the estate tax on the survivor’s death. Surprisingly, President Obama’s proposals also include the “portability” concept, which is not without its own problems. For example, did you know that the IRS will have the power to audit a deceased spouse’s estate if the surviving spouse uses the decedent’s exemption? So, if a surviving spouse dies 40 years after the first spouse, the IRS effectively can look 40 years into the past and audit the first spouse’s as well as the survivor’s estate tax returns!
GRATs and Valuation Discounts. A grantor retained annuity trust (GRAT) has proven to be a popular technique for moderately wealthy and über-wealthy taxpayers to transfer appreciating assets to family members. The creator (or grantor) of the GRAT contributes appreciated or appreciating assets to the trust, which may include minority interests in closely held business entities. The trust must pay the grantor an annuity equal to or greater than the value of what was contributed. Usually, the GRAT term very short, often only two years in duration. If the contributed assets are appreciating rapidly (think pre-merger value of a privately held company!) and if valuation discounts are used to further depress the values of the contributed assets (because they are minority interests in privately held businesses), the appreciation in the assets will far exceed the amount of the annuity due to the grantor and therefore will pass gift and estate tax-free to the GRAT beneficiaries. For more info on how GRATs work, see /grantor-retained-annuity-trusts.html#tp.
President Obama has proposed two changes (both were in last year’s budget proposals) that would curtail the ability to use short-term GRATs and valuation discounts on transfers to or for the benefit of family members. Specifically, the shortest GRAT term would be 10 years, which effectively would eliminate the technique from common usage. Also, GRATs would no longer be able to be zeroed out, such that some gift tax would have to be paid or a portion of the gift tax exemption would have to be used on the creation of the GRAT. Finally, the President would preclude the use of valuation discounts on transfers of certain closely held business assets to family members or entities for their benefit. As a result of the President’s proposals, professional advisors once again are scrambling and urging clients to make gifts to take advantage of valuation discounts, establish GRATs and engage in other advanced planning involving valuation discounts before Congress embraces the President’s proposals.
Dynasty Trusts. The GST tax is imposed at the highest estate tax rate on gifts to transferees who are two or more generations younger than the transferor. Taxpayers have been able to avoid the onerous GST tax by using so-called dynasty trusts. These multi-generational trusts have been designed legitimately to avoid both estate and GST tax on the death of the beneficiaries of the trusts. Now that the estate tax and GST tax exemptions have increased (albeit temporarily) to $5 million, the transfer tax system can be circumvented using properly structured dynasty trusts.
President Obama’s proposals would provide that, following the 90th anniversary of the creation of a trust, the GST tax could once again apply to distributions from the trust. Fortunately, for those who have already created dynasty trusts, the proposal would not apply and only would capture trusts created after date of enactment.
Conclusion. Of course, as in prior years, there is no certainty that the President’s budget proposals will pass. Some speculate that the Congress will soundly defeat the President’s budget reform proposals. Others are running scared of the proposals and urging clients to take immediate action. In any case, these constant changes in the tax landscape certainly are keeping us busy!