A Sea Change for Gift and Estate Planning

By Paul Bonner

PFP practitioner, writer and lecturer Martin Shenkman outlines opportunities and caveats.

Martin Shenkman, Esq., CPA/PFS, is the author of numerous books and articles on tax and financial planning, including the AICPA-published Estate and Related Planning During Economic Turmoil, and with Steve R. Akers, Estate Planning After the Tax Relief and Job Creation Act of 2010: Tools, Tips, and Tactics. His firm, Martin M. Shenkman PC of Paramus, N.J., and New York City, specializes in serving tax and estate and business planning needs of high-net-worth individuals, professionals, owners of closely held businesses, and real estate developers. Shenkman is also a frequent lecturer on financial planning, on which he is regularly quoted in a wide range of media. Recently, he spoke with the JofA on gift and estate tax and how CPAs can advise their clients to help them make sense of the recent changes in gift and estate tax, deal with uncertainty ahead, and make the most of current opportunities.

JofA: How should CPAs and their clients prepare for uncertainty after 2012 for the estate and gift tax?

Shenkman: The single most important point is not to dismiss planning as something that now only pertains to the ultra-wealthy. Planning remains vital for most clients. Practitioners are well aware that in 2013, what’s on the books now is that we’re going to have a $1 million gift and estate tax exemption (the GST [generation-skipping transfer] exemption will be $1 million, too, but inflation-indexed), and we’re going to have a 55% tax rate. Very few practitioners really believe that’s going to happen, but it cannot be dismissed when consulting with clients. What will happen, I don’t think anybody truly knows. So a lot of people are believing we can “wait and see,” until maybe mid-2012 or late 2012, what to do before we act. And that could prove to be a very big mistake. Wait and see may become “wait and pay.” The safer and smarter approach is to proactively plan flexibly, so that whatever changes occur, the client will be in a better position than if no planning had been undertaken.

Meanwhile, the situation now offers a golden planning opportunity. The gift exemption is $5 million, the highest it’s ever been in history, which permits huge wealth shifts. Besides the scheduled reduction of that exemption, there have been proposals to restrict GRATs (grantor retained annuity trusts) to a 10-year term. And the current practice of discounting values of private partnership interests or other forms of equity for lack of marketability or control may face restrictions as well. The Obama administration has already proposed reducing the gift exemption to $1 million.

There’s also an economic imperative to planning. Interest rates have started to rise, and as that happens, the leverage from note sale transactions, GRATs and other techniques diminishes. The economy is still very soft, so that you may still get some historically favorable valuations.

Let me point out several opportune client scenarios for which practitioners should try to help plan for current gifts. If you have a client who lives in one of the almost 20 states, give or take, that have decoupled from the federal estate tax system, that client may face a substantial estate tax at the state level even though he or she might have no federal tax. Because of the $5 million federal gift exemption, if you have a client in his or her late 80s, or who is ill, for example, who lives in New York, which has a $1 million exemption, that client may be able to simply gift away assets today, with no federal gift tax, reducing them to, say, $995,000. When that client passes away, there’s no New York estate tax. They have almost a half-million-dollar savings. It can be that simple (but watch for changes in state estate or gift tax laws). Many clients who are candidates for this type of planning won’t be willing to part with such a large portion of their wealth. There are several options. First, gift something substantial but less than the maximum necessary. The savings can still be substantial. The other approach, which is more complex and costly, is really the optimal planning technique for many clients. Gift the assets to a domestic self-settled asset protection trust (DAPT). These are typically formed in Alaska, Nevada, Delaware or South Dakota. The client can remain a discretionary beneficiary of an independent trustee and thus benefit from his or her assets if needed. Yet the assets should be removed from his or her estate. While there are risks with this planning, the risks of doing nothing certainly could be much more costly.

The second category of client is—I would use physicians as the key example, but it applies really to a broad array of clients. Anyone who is concerned about asset protection, lawsuits, malpractice, divorce or other litigation should plan aggressively now, because this is a golden opportunity to shift wealth. The $5 million gift exemption permits tremendous asset protection planning. The DAPT noted above might be one approach. The third category are gay or lesbian partners or other nonmarried couples. In the past, where you had one partner with more wealth than the other, shifting wealth from that partner to the less wealthy partner has been a very complicated process, often requiring complex and expensive planning techniques to avoid incurring a gift tax. But with a $5 million exemption, you may be able to simply set up a trust for that other partner and shift wealth, and you’re done.

JofA: What about a possibly awkward transition with the changes between 2010 and 2011?

Shenkman: One of the most important issues is that the zero GST, generation-skipping transfer tax, in 2010 gave many clients a unique opportunity to do things they’d never done before. So, for example, if you had a pot trust that was not GST-exempt but could make distributions to a grandchild or other skip person, a lot of clients or trustees would have made those distributions to grandchildren to shift assets out, because even if it was a GST transfer, there was no GST tax.

The problem and challenge for practitioners is, first of all, to ferret out those transfers, because clients may not realize what needs to be done in order to report them on the trust income tax returns. It’s not just the gift tax return you have to focus on, but it’s the income tax returns as well. You now had a distribution out of a trust. You’ve got to report that on the Form 1041 [U.S. Income Tax Return for Estates and Trusts], not just the Form 709 [United States Gift (and Generation-Skipping Transfer) Tax Return]. And the gift tax returns for 2010 are extremely complex and different from any other tax year. Most practitioners extended 2010 gift tax returns for this reason and still have to face the issues they raise. Determining whether or not to affirmatively allocate GST exemption, to opt out of the automatic GST allocation rules, how to report purported gifts that may have been rescinded, qualified severances used to take advantage of 2010 law, and other issues will have to be addressed.

Another big issue is that some practitioners were reasonably advising elderly or sick clients, “Make large taxable gifts now. You’ll secure them at a 35% rate, because in 2011, we’re going to have a million-dollar gift exemption and a 55% rate.” At the time those words were spoken, they were fairly reasonable. Few practitioners anticipated continuation of the 35% rate, but no one anticipated the $5 million gift exemption. So now, if they’d only waited until after Jan. 1 this year, they could have made those gifts free of gift tax. There still may be ways through rescission, disclaimers and other techniques to try to either unwind those gifts or redirect them to avoid the gift tax. Perhaps a series or tier of disclaimers may be able to wind the gift back under the intestacy law or under state law to the donor or to a spouse to effectively negate it. It needs to be looked at and evaluated.

Practitioners should be especially alert to issues that may arise if state law and federal tax law differ, or for clients whose attorneys filed court cases to interpret wills or gift transfers in light of the law changes. It may not be possible to ascertain with certainty the status of a transfer until a court hearing is resolved. Perhaps for the first time in history, practitioners will have to determine what to report on a Form 709 for a gift that “wasn’t.” The special nine-month extension of the time periods for filing and disclaiming under the [Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010] push much of this planning further into 2011 than the general rules would permit.

One of the most complicated gift tax issues is that attorney practitioners set up trusts that were unique to 2010 because you could have only skip persons—grandchildren and further descendants—as beneficiaries, but unlike your traditional or typical GST-exempt trust, it was not designed or intended to go on in perpetuity, but rather merely to provide for one GST skip. Remember the old saying, “If it looks like a duck, walks like a duck and quacks like a duck, it’s probably a duck”? Well, not necessarily so with 2010 GST trusts. A trust may look like any other GST trust created in any tax year to which the GST automatic allocation rules would allocate GST exemption. But if the grantor/donor’s intent was not to allocate GST exemption, that trust, and how the gifts would be reported for gift tax purposes, how investments and distributions would be handled, would all differ.

Here’s an example: If grandpa set up a trust in 2010 for his grandchildren, because there were only grandchildren as beneficiaries, the trust itself would be a skip person. The GST automatic allocation rules would apply and allocate GST exemption to protect that trust from future GST tax. In every year except 2010, that is precisely what the client would want. But because the GST tax rate was zero for 2010 transfers, there would be no GST tax on gifts to the trust in 2010. There would not be a GST tax due on distributions to the grandchildren because of the “move down” rule, which would treat the child (not grandpa) as the transferor. However, GST tax could be due on distributions to later descendants if GST exemption was not allocated. So if the client’s plan is that the trust will be distributed out and used for grandchildren only, the GST automatic allocation rules would waste GST exemption by allocating GST exemption to this trust (since there will never be a GST tax). So, unlike any other tax year, practitioners will want to expressly opt not to have GST exemption allocated on gift tax returns for this type of trust.

But back to the duck metaphor: This same trust might be intended to last in perpetuity and be a true dynasty trust. In that case, GST exemption should be allocated to the transfers to the trust. The complexity for practitioners is that both trusts look like GST ducks, but only one really is (the latter).

How you plan the investments, if you’re a practitioner who’s helping the client invest those funds, is unique, because it’s not to be invested in perpetuity. The time frame for that trust is merely the life period of the grandchildren, not perpetual. That, in turn, will affect the income tax planning on the Form 1041, because it’s a different paradigm than what you’d use for a traditional GST trust.

Practitioners will in many instances have to confer back with the attorneys who drafted the trust to ascertain what was intended.

JofA: How do the changes affect other aspects of wealth planning, such as insurance?

Shenkman: The 2010 tax law changes were such a sea change that practitioners really need to step back and re-evaluate the entire insurance plan for a client.

The client may have a life insurance policy because they were going to use a survivorship or second insurance policy to pay estate tax when we had a $2 million exemption. Now that we have a $5 million exemption and portability—and the Obama administration has recommended that portability be made permanent— aside from the state estate tax issue, they no longer have the same need for that life insurance. The practitioner should re-evaluate that insurance and see whether it’s worth maintaining as part of the plan.

Rather than dropping it, given the uncertainty of what 2013 may bring, it may be preferable to evaluate that permanent insurance policy and determine, “OK, here’s the minimum amount we can pay per year in 2011 and 2012 to maintain that policy, and then we’ll reassess what happens in 2013, but we’ve maintained the coverage just in case.” This way, if there’s a health issue that arises or we end up with that $1 million exemption that’s on the books that no one thinks will happen, we have the coverage in place. But in the meantime, you’ve been very proactive and helpful to the client because you’ve minimized their cash outlay and really addressed their planning more critically. On the other hand, if the insurance serves other important planning goals such as asset protection, a ballast for an aggressive investment allocation, etc., then perhaps no change would be in order. Remember, most good insurance plans have insurance serving multiple purposes. Clients should not cancel a policy even if the estate tax purpose has been eliminated, if other objectives are still served.

We could end up with some type of carryover basis regime, however distasteful people find it, so before you cancel that life insurance, that may be the ticket to pay for those capital gains. The economic downturn, the stock market roller coaster the past few years, have demonstrated that, for some clients, insurance is a ballast for their overall investment portfolio. So again, before you cancel it, evaluate the investment options.

Finally, insurance can be a great asset protection tool. The value that grows inside a life insurance policy held inside an irrevocable life insurance trust (ILIT) has considerable protection. There is a common spin on the typical ILIT that is used with asset protection motives in mind. Life insurance on one spouse, say the husband, can be held in an ILIT, with the wife as a beneficiary and co-trustee. This spin on the typical ILIT is commonly referred to as a “SLAT,” a spousal lifetime access trust. An independent trustee can borrow on the policy and make distributions to the spousal beneficiary. Many trust agreements limit the spouse’s power to distribute to himself or herself to an ascertainable standard to minimize the risk of estate inclusion. Other trust agreements prohibit a distribution to oneself, or one that would discharge one’s obligations of support (for a minor child). A number of variations can be chosen depending on how the client weighs control vs. possible protection. It’s a great way to protect assets.

There’s a myriad of different applications of insurance, but they all need to be re-evaluated in terms of what the 2010 act did. Importantly, contrary to many clients’ kneejerk reactions to cancel coverage because they don’t need to worry about an estate tax, asset protection and other benefits, coupled with the $5 million gift exemption might actually weigh in favor of some clients increasing coverage, or shifting from term to permanent coverage.