Category: Estates & Trusts

Supreme Court Limits Bankruptcy Court Jurisdiction – Stern v. Marshall

Posted recently at the National Law Review by Prof. G. Ray Warner of Greenberg Traurig, LLP – the latest installment of the Anna Nicole Smith / J. Howard Marshall estate issue and how it impacts the jurisdiction of bankruptcy courts:   

 

In a decision that may create serious problems for bankruptcy case administration, the Supreme Court this morning invalidated part of the Bankruptcy Court jurisdictional scheme. Stern v. Marshall, No. 10-179, 564 U.S. ___ (June 23, 2011). Specifically, the Court held that the Bankruptcy Courts cannot issue final judgments on garden variety state law claims that are asserted as counterclaims by the debtor or trustee against creditors who have filed proofs of claim in the bankruptcy case.

Thus, while the Bankruptcy Court could issue a final order resolving the creditor’s claim against the estate, it could issue only a proposed ruling with respect to the counterclaim. Final judgment on the counterclaim could only be issued by the District Judge after de novo review of any matters to which a party objects. See 28 U.S.C. § 157(c).

In a five-to-four opinion by Chief Justice Roberts, the Court affirmed the Ninth Circuit Court of Appeals decision that had reversed an $88 million judgment in favor of Vickie Lynn Marshall (a/k/a Anna Nicole Smith) against E. Pierce Marshall for tortious interference with Vickie’s expectancy of a gift from her late husband J. Howard Marshall, Pierce’s father and one of the richest people in Texas.

The Court’s decision was based on constitutional principles defining the limits of Article III of the U.S. Constitution. Thus, it is likely to have implications that reach far beyond the narrow issue resolved in the instant case. The majority relies on the “public rights” doctrine to define the class of judicial matters that can be resolved by non-Article III tribunals like the Bankruptcy Courts. However, it adopts a narrower view of what constitutes “public rights” than was generally understood prior to this decision.

In addition, although earlier cases could be read to adopt a flexible pragmatic approach to Article III that focused only on significant threats to the Judiciary, Chief Justice Roberts takes a very firm approach, stating, “We cannot compromise the integrity of the system of separated powers and the role of the Judiciary in that system, even with respect to challenges that may seem innocuous at first blush.” Of particular interest, this case focuses on the nature of the Bankruptcy Judge as a non-Article III judge (i.e., no life tenure and no salary protection) and rejects the view that the Bankruptcy Courts are merely “adjuncts” of the Article III District Courts. Note that the “adjunct” construct was one of the foundations of the 1984 Act’s post-Northern Pipeline jurisdictional fix that created the core/non-core distinction. See Northern Pipeline Co. v. Marathon Pipe Line Co., 458 U.S. 50 (1982).

The narrow holding is that Bankruptcy Judges, as non-Article III judges, lack constitutional authority to hear and “determine” counterclaims to proofs of claim if the counterclaim involves issues that are not essential to the allowance or disallowance of the claim. Here, although the counterclaim was a compulsory counterclaim, it was a garden variety state law tort claim and did not constitute a defense to the proof of claim. Contrast this with the preference claim involved in Langenkamp v. Culp, 498 U.S. 42 (1990). The receipt of such an unreturned preference is a bar to the allowance of the claim. See 11 U.S.C. 502(d). The opinion also distinguishes Langenkamp (and the earlier pre-Code case of Katchen v. Landy, 382 U.S. 323 (1966)) on the ground that the preference counterclaims in those cases were created by federal bankruptcy law. It is unclear whether that reference establishes a second condition to Bankruptcy Court resolution of counterclaims — i.e., that the counterclaim be based on bankruptcy law in addition to its resolution being essential to claim allowance.

The Court begins its opinion by interpreting the “core” jurisdictional grant of 28 U.S.C. 157(b)(1). The Court finds the provision ambiguous, but rejects the view of the Ninth Circuit that the Bankruptcy Court’s jurisdiction to determine matters involves a two-step process of deciding both whether the matter is “core” and whether it “arises under” the Bankruptcy Code or “arises in” the bankruptcy case. The Court states that such a view incorrectly assumes there are “core” matters that are merely “related to” the bankruptcy case (and which cannot be “determined” by the Bankruptcy Court). The Court states that core proceedings are those that arise in a bankruptcy case or arise under bankruptcy law and that noncore is synonymous with “related.” Thus, since counterclaims to proofs of claim are listed as core in the statute, the Bankruptcy Court has statutory authority to enter final judgment. (Note that the opinion does not explain how a tort claim that arose before the bankruptcy and that was based on non-bankruptcy state law could be a claim “arising in” the bankruptcy case or “arising under” bankruptcy law. Possibly the fact that procedurally it arises as a counterclaim is sufficient to convert a “related” claim into an “arising in” or “arising under” claim. Cf. Langenkamp.)

The Court also rejects the argument that the personal injury tort provision of 28 U.S.C. 157(b)(5) deprives the Bankruptcy Court of jurisdiction to resolve the counterclaim. The Court holds that section 157(b)(5) is not jurisdictional and thus the objection was waived.

Although the statute authorized the Bankruptcy Court to determine the counterclaim, the Court holds that grant violates Article III. The Court rejects the view that the Article III problem was resolved by placing the Bankruptcy Judges in the judicial branch as an “adjunct” to the District Court. The Court focuses on the liberty aspect of Article III and its requirement of judges who are protected by life tenure and salary guarantees. After outlining the extensive jurisdiction of Bankruptcy Judges over matters at law and in equity and their power to issue enforceable orders, the Court states “a court exercising such broad powers is no mere adjunct of anyone.”

The Court then uses the “public rights” doctrine as the test for which matters can be delegated to a non-Article III tribunal. Although Granfinanciera v. Nordberg, 492 U.S. 33 (1989), suggested a balancing test that considered both how closely a matter was related to a federal scheme and the degree of District Court supervision (a test that arguably supports the Bankruptcy Court’s entry of a judgment on a compulsory counterclaim), the Court settles on a new test for public rights limited to “cases in which resolution of the claim at issue derives from a federal regulatory scheme, or in which resolution of the claim by an expert government agency is deemed essential to a limited regulatory objective within the agency’s authority.” The state common law tort counterclaim asserted here does not meet that test. Instead, adjudication of this claim “involves the most prototypical exercise of judicial power.”

Interpreted in the most restrictive fashion, this ruling might create serious problems for case administration. In proof of claim matters, the Bankruptcy Court would be limited to proposed findings on most counterclaims, with the District Court entering the final order after de novo review. Query whether the majority’s limited view of “public rights” would prevent the Bankruptcy Judge from entering final judgment in other disputes that involve the non-bankruptcy rights of non-debtor parties. Bankruptcy Courts regularly resolve inter-creditor disputes and resolve disputes regarding the non-bankruptcy rights of parties to the bankruptcy case in contexts other than claim allowance. Whether the Bankruptcy Court’s exercise of this power is constitutional may turn on how broadly the courts interpret the “cases in which resolution of the claim at issue derives from a federal regulatory scheme” prong of the “public rights” test.

©2011 Greenberg Traurig, LLP. All rights reserved.

 

Planning Opportunities Under the New Estate and Gift Tax Law

Recently posted at the National Law Review by Julia L. Frey, Matthew R. O’Kane, and Norma Stanley of Lowndes, Drosdick, Doster, Kantor & Reed, P.A. – some highlights of the recent tax changes impacting estate plans:  

On December 17, 2010, Congress enacted a new tax law which changes the federal gift, estate and generation-skipping transfer (“GST”) taxes currently in effect. However, the new law is only effective for the next two years, through December 31, 2012. The new law increases the lifetime exemptions for the estate, GST and gift taxes to $5,000,000 per person and reduces the top tax rate to 35%.

The increased gift tax exemption allows you to make tax-free gifts of your estate which might otherwise be subject to gift tax. The new gift tax provisions allow someone who has already made taxable gifts totaling $1,000,000 during his or her life to have an additional $4,000,000 of gift tax exemption available for his or her use. This is an immediate planning opportunity for those who wish to take advantage of the tax law changes.

The new law may also alter many estate plans. For example, assume your estate is to be divided into a family trust and a marital trust with the family trust being funded with the maximum estate tax exemption and the marital trust being funded with the amount, if any, of the estate that exceeds the exemption amount. Thus, under current law, the family trust would be funded with the first $5,000,000 of the estate (or the entire estate depending upon the estate’s value) with the possibility that no portion of the estate would pass into the marital trust. Given the increased exemption, this may or may not be what you would want to happen.

The new law provides for “portability” of the estate tax exemption. Under prior law, if the estate of the first spouse to die did not use that spouse’s exemption, it was lost. Now, a surviving spouse may elect to add the deceased spouse’s unused exemption to the surviving spouse’s exemption, thereby increasing the surviving spouse’s estate and gift tax exemption for transfers during life or upon death. For instance, if the first spouse dies and only used $2,000,000 of his $5,000,000 estate tax exemption, the surviving spouse would now be able to elect to shelter $8,000,000 from estate and gift tax (the surviving spouse’s exemption of $5,000,000 plus the deceased spouse’s unused $3,000,000 of exemption).

While the new tax law is a step in the right direction, it only applies through December 31, 2012. Whether your estate is above or below the new exemption amount, it is important to make sure your estate plan is up-to-date to ensure your intent is carried out and to maximize all of the planning options currently available to you. In addition, if a family member passed away in 2010, there could be new planning opportunities available that may benefit the estate.

© Lowndes, Drosdick, Doster, Kantor & Reed, PA, 2011. All rights reserved.

Planning Opportunities Under the New Estate and Gift Tax Law

Recent post summarizing Gift and Estate Tax changes at the National Law Review by Lowndes, Drosdick, Doster, Kantor & Reed, P.A. – read on: 

On December 17, 2010 Congress enacted a new tax law which changes the federal gift, estate and generation-skipping transfer (“GST”) taxes currently in effect. However, the new law is only effective for the next two years, through December 31, 2012. The new law reinstates the lifetime exemptions for the estate, GST and gift taxes and increases the amount of the exemptions to $5,000,000 per person with a top tax rate of 35%.

The law provides new opportunities for clients. The increased gift tax exemption allows for clients to make tax-free gifts of their estate which might otherwise be taxable. The new gift tax provisions allow someone who has already made taxable gifts totaling $1,000,000 during his or her life to have an additional $4,000,000 of gift tax exemption available for use during his or her life. This is an immediate planning opportunity for clients who may wish to take advantage of the tax law changes.

The new law may also alter many clients’ estate plans. For example, assume a client’s estate plan is drafted to provide that the estate is to be divided into a family trust and a marital trust with the family trust being funded with the maximum estate tax exemption and the marital trust being funded with the amount, if any, of the estate that exceeds the exemption amount. Thus, under current law, the family trust would be funded with the first $5,000,000 of the estate (or the entire estate depending on the value of the estate) with the possibility that no portion of the estate would pass into the marital trust. Given the increased exemption, this may or may not be what a client would want to happen.

Many clients’ current estate plans include a family trust to ensure the use of the first spouse’s estate tax exemption because the prior law provided if the estate exemption was not used at the first spouse’s death it was lost. The new law provides for “portability” of the estate tax exemption. Thus, a surviving spouse may elect to add the deceased spouse’s unused estate and gift tax exemption to the surviving spouse’s exemption, thereby increasing the surviving spouse’s estate and gift tax exemption for transfers during life or upon death. For instance, if the first spouse dies and only used $2,000,000 of his $5,000,000 estate tax exemption, upon election, the surviving spouse would now be able to shelter $8,000,000 from estate and gift tax (the surviving spouse’s exemption of $5,000,000 plus the deceased spouse’s unused $3,000,000 of exemption).

The new law also applies to the estates of individuals who died in 2010 and who may wish to take advantage of some of the planning opportunities. If a family member passed away in 2010, you may want to discuss what planning opportunities are available related to the estate with your estate attorney.

While the new tax law is a step in the right direction, it only applies through December 31, 2012. Therefore, it is important to confirm your estate planning documents are drafted to address the changing tax law as well as to take advantage of the new opportunities that are currently available and may expire in two years. Even if your estate is below the new exemption amount, it is still important to make sure your estate plan is up to date to ensure your intent is carried out and to maximize all of the options available to you. 

© Lowndes, Drosdick, Doster, Kantor & Reed, PA, 2011. All rights reserved.

Congress Finally Resolves Estate Tax Uncertainty: But Only for Two Years!

Very Comprehensively written article by Michael D. Whitty and Igor Potym of Vedder Price P.C. – so much good Year End Tax Information we thought we’d include it here too:  

As part of a compromise to extend the income tax rates in effect from 2003 to 2010 (sometimes described as the “Bush tax cuts”) and unemployment benefits, Congress has finally resolved uncertainties in the estate, gift, and generation-skipping transfer (“GST”) taxes.  The new law makes the most significant changes to these taxes since 2001, including a generous increase in exemptions and a significant reduction in tax rates for 2011–2012.  In order to take advantage of some one-time wealth transfer opportunities, action is required before the end of 2010. For nearly all high-net-worth persons, the next two years will bring extraordinary estate planning opportunities.  Unfortunately, and contrary to many media claims, 2011 and 2012 will also bring added complexity and uncertainty.  Surprisingly, estate planning for married persons with estates of less than $10,000,000 may actually be more complicated than planning for married persons with larger estates.  Accordingly, all estate plans should be reviewed early in 2011 to determine whether the plan will work as intended under the new tax laws.  Persons who would like to discuss how the new estate, gift, and GST tax laws affect their specific situations and existing estate plans should call a member of the Estate Planning Group of Vedder Price P.C.

Executive Summary

The following is an executive summary of the most notable effects of the new law; a more detailed discussion of each can be found inside this Bulletin:

  • Income Tax Rates Continued for 2011–2012. The 2010 income tax rates are continued for two more years, including the preferential 15% tax rate for long-term capital gains and qualified dividends.
  • Estate Tax Made Optional for 2010.  The estate tax, which had been repealed for 2010, was reinstated effective January 1, 2010, but the executor for a person dying in 2010 may elect to opt out of the estate tax and apply carryover basis instead.
  • Transfer Tax Exemptions Increased, Tax Rate Reduced.  The lifetime exemption amount for transfer taxes—the estate tax, gift tax, and GST tax—is set at $5,000,000.  These increases are effective in 2010 except for the gift tax exemption, which remains $1,000,000 until 2011.  The tax rate on estates, gifts, and generation-skipping transfers above these amounts is 35%.
  • Generation-Skipping Transfer Tax Rate Is Zero for 2010. For all of 2010 (including the balance of the year), the GST tax rate is zero.
  • Unused Estate Tax Exemption Transferable to Surviving Spouse.  Beginning in 2011, the unused estate and gift tax exemptions of the first spouse to die may be transferred to the surviving spouse for both gift and estate tax purposes.
  • Bullets Dodged. The new legislation did not include recent proposals to reduce or eliminate the effectiveness of several of the most advantageous estate planning techniques.
  • Direct Gifts from IRAs to Charities Reinstated for 2010–2011. In 2008–2009, IRA owners over age 70½ could make direct distributions from their IRAs to charities and exclude the amount from income while treating it as part of their required minimum distribution.  The new law extends that option through 2011.  Because so little time remains in 2010, a special rule permits taxpayers to make such a transfer in January 2011 and treat it as if it had been made on December 31, 2010.

The “Tax Relief, Etc.” Act of 2010

The bill passed by Congress and signed by President Obama on December 17, 2010, H.R. 4853, was titled the “Tax Relief, Unemployment Insurance Authorization, and Job Creation Act of 2010” in its final form.  (It had previously carried other names, including the “Middle Class Tax Relief Act of 2010.”)  For simplification, this Bulletin will refer to it as the “2010 Tax Act” or “the Act.”

The bill went through many changes in the last month prior to enactment, and includes some unexpected provisions while excluding other provisions that had been expected.  As a result, some of our recommendations from prior bulletins have changed.  Please contact a member of our Estate Planning Group for confirmation before acting on our prior recommendations.

The benefits of the Act may be temporary, however.  All of the tax changes included in the Act will expire on or before January 1, 2013. Without further action by Congress, the estate, gift, and GST tax rates and exemptions applicable on January 1, 2001 will return on January 1, 2013.  Additional legislation in late 2012 or early 2013 seems likely, but it is impossible to predict the details of that legislation.

Income Tax Rates Continued for 2011–2012

The Act continues the 2009 income tax rates through 2012, including the preferential 15% tax rate for long-term capital gains and qualified dividends.  Apart from other changes discussed later in this Bulletin, these changes include:

  • Withholding of Social Security tax from wages and self-employment income for 2011 decreased by two percentage points (with the gap made up from general federal revenues)
  • AMT “relief” for most taxpayers through 2011
  • Ability to deduct state sales tax as an itemized deduction through 2011
  • Enhanced business capital investment deductions and research and development credits

Summary of Changes to Transfer Tax Rates and Exemptions

2009 2010 2011–2012 2013 (if no action)
Tax: Exemption Rate Exemption Rate Exemption Rate Exemption Top Rate
Gift $1,000,000 45% $1,000,000 35% $5,000,000 35% $1,000,000 55%
Estate $3,500,000 45% $5,000,000 [1] 35% $5,000,000 35% $1,000,000 55%
GST $3,500,000 45% $5,000,000 0% $5,000,000 35% $1,400,000 [2] 55%
Notes: [1] Executors for decedents dying in 2010 may opt out of estate tax, into carryover basis.
[2] The GST exemption shown for 2013 is a projection, as it would be $1,000,000 indexed for inflation.

Estate Tax Made Optional for 2010

Under the 2001 tax act, the estate tax had been gradually eased, and was then repealed for one year only, 2010.  The new Act reinstates the estate tax and stepped-up basis (used for measuring capital gains) effective January 1, 2010.  This default rule benefits most estates that are too small for estate taxes but benefit from having stepped-up basis automatically apply to all assets.  However, the executor of a 2010 estate may elect to opt out of the estate tax and instead apply carryover basis (where the heirs take the decedent’s basis).  (See the item below regarding due dates.)

Transfer Tax Exemptions Increased, Tax Rates Reduced

The Act resets the estate tax exemption to $5,000,000 per decedent, effective January 1, 2010 (up from $3,500,000 in 2009).  The exemption for the GST tax is also $5,000,000 effective January 1, 2010.  The Act also increases the gift tax exemption to $5,000,000 to re-unify it with the estate tax exemption, but that change is delayed until 2011.  These exemption amounts are also adjusted for inflation, beginning in 2012.  However, all of these exemptions will revert to $1,000,000 in 2013 unless Congress takes additional action.  The Act sets a 35% tax rate on estates, gifts, and generation-skipping transfers above the exemption amounts.  This compares favorably with the 45% top rate that applied in 2009, and the 55% rate that would have applied in 2011 if Congress had not acted (and will apply in 2013 if Congress fails to take additional action).

The Act also changes how prior taxable gifts are taken into account in gift and estate tax calculations, by applying the tax rates for the year in question rather than the year of the prior gifts.  In our October 2010 Bulletin, we described how the transition in the gift tax rates and exemption from 2010 to 2011 would allow some donors who had already used all of their gift tax exemption to make a modest additional tax-free gift of $36,585 in 2011.  The Act’s changes in the gift tax rate, exemptions, and calculations of taxes on prior taxable gifts will eliminate that effect for 2011, but will allow much more extensive tax-free gifts.

Due Dates for 2010 Returns, Disclaimers

To prevent unfairness, the Act extends the due date for all estate and GST tax returns affected by the Act until September 17, 2011, nine months after the date of enactment (as that date falls on a Saturday, the effective date will be September 19, 2011).  The due date for related tax payments is also extended to the same date.  The deadline for qualified disclaimers (an affirmative election to decline a gift or bequest, treated under federal law as if the disclaimant had predeceased the transfer) is also extended to September 17, 2011.  However, the due date for 2010 gift tax returns was not extended.

Generation-Skipping Transfer Tax Rate Fixed at Zero for 2010

The Act sets the GST tax rate at zero for all of 2010 (including the balance of the year after enactment).  This means that gifts, bequests, trust terminations, and trust distributions to grandchildren made this year will face no GST tax.  If the transfer was made to a trust for a grandchild, the GST tax consequences are more tricky.  Neither the transfer to the trust nor a future distribution to the grandchild will be subject to GST tax. However, future distributions from the trust to great-grandchildren or younger descendants will be subject to GST tax unless the trust is made exempt by allocation of the transferor’s GST exemption.  In addition, a transfer in 2010 to a typical generation-skipping trust that benefits children, grandchildren, and younger descendants will not be exempt from GST tax in the future unless the trust is made exempt by allocation of the transferor’s GST exemption.  If you have already made or plan to make gifts to grandchildren in 2010, contact a member of our Estate Planning Group to discuss the effects of the new Act, including reporting requirements and tax elections.

Unused Estate Tax Exemption Transferable to Surviving Spouse

Beginning in 2011, the unused estate tax exemption of the first spouse to die may be transferred to the surviving spouse by an election filed with the first spouse’s estate tax return.  This may require the filing of an estate tax return in cases where a return would not otherwise be required.  The surviving spouse may use this transferred exemption for lifetime gifts as well as for bequests at death.  Only the unused exemption from the last deceased spouse will apply, and the death of a subsequent spouse will reset the identity of the last deceased spouse.  However, lifetime gifts could use a predeceased spouse’s exemption before the death of a subsequent spouse changes the amount of exemption available.

For planning purposes, transferability of the unused estate tax exemption of the first spouse does not eliminate the value of so-called credit shelter trusts and QTIP trusts as part of the estate plan.  As one example, the new law does not allow the unused GST tax exemption of the first spouse to be transferred to the surviving spouse.  The credit shelter trust and QTIP trust are two tools to avoid wasting the first spouse’s GST tax exemption.

Bullets Dodged

The Tax Reform Act of 2010, in its final form, did not include recent legislative proposals (some of which had already passed in the House or Senate, but not both) to reduce or eliminate the effectiveness of several of the most attractive estate planning techniques.  The final legislation did not include recent proposed legislation to reduce or eliminate valuation discounts on intra-family transfers of non-operating partnerships and LLCs, to impose a 10-year minimum term on grantor retained annuity trusts (commonly known as GRATs), or to require taxpayers to use a consistent basis for estate and income tax purposes.

Direct Gifts from IRAs to Charities Reinstated for 2010–2011

In 2008–2009, IRA owners over age 70½ could make direct distributions from their IRAs to charities of up to $100,000 per year and exclude the amount from income, while treating it as part of their required minimum distribution.  The new law extends that option through 2011.  Because so little time remains in 2010, a special rule permits taxpayers to make such a transfer in January 2011 and treat it as if it had been made on December 31, 2010.

Roth Conversions

The new Act did not change the rules regarding Roth IRA conversions, discussed in prior Bulletins.  The only thing that expired in 2010 was the election to report the tax over the following two taxable years (2011 and 2012).  Conversions in 2011 will still work as in 2010, except that the taxable income has to be recognized entirely in 2011.

The New Law’s Effect on Estate Planning

The fundamental principles and priorities of estate planning will remain the same.  However, the effect and relative value of certain specific techniques have changed.  Some opportunities have been improved, others have disappeared, and still others remain but have decreased in relative importance.

As noted at the opening of this Bulletin, the new tax laws create extraordinary estate planning opportunities for high-net-worth individuals.  Additionally, the new tax laws will impact the basic estate plan of nearly all persons with significant assets.  Estate planning for married persons with combined estates of less than $10,000,000 will be particularly complex, given the possibility that the estate, gift, and GST tax exemptions will revert to only $1,000,000 per person in 2013.

Time for Action

A few of the opportunities described in this Bulletin have an absolute expiration date:  December 31, 2010. Others may expire as soon as December 31, 2012.

© 2010 Vedder Price P.C.

Other Super Year-end Tax and Estate Planning Articles:

FEDERAL TAX NOTICE:  Treasury Regulations require us to inform you that any federal tax advice contained herein (including in any attachments and enclosures) is not intended or written to be used, and cannot be used by any person or entity, for the purpose of avoiding penalties that may be imposed by the Internal Revenue Service.

Time Is Running Out for One-Time Estate Planning Opportunities: Gift Tax Rates Will Increase in 2011, Bonus Gift Tax Exemption Available for Some Gifts Made in 2010-11 and Opportunity for Gifts or Trust Distributions to Grandchildren

Very comprehensive post recently received at the National Law Review from Michael D. Whitty of Vedder Price P.C. on year end estate and tax planning issues: 

As the end of the year approaches, it appears increasingly unlikely that Congress will pass legislation on gift and estate taxes before 2011.  Many one-time opportunities for gifting and tax planning will expire at the end of 2010.

Executive Summary:

  • Gift Tax Will Increase in 2011. For 2010 only, the tax rate on gifts that exceed the $13,000 gift tax annual exclusion and the $1 million lifetime gift tax exemption is only 35%, compared to a 45% rate in 2009 and rates of up to 55% in 2011 and beyond.  Persons who are otherwise facing substantial estate taxes should consider making gifts this year to take advantage of the 35% rate.
  • Bonus Gift Tax Exemption Available for Some Gifts Made in 2010–2011. Due to quirks in the way the $1 million lifetime gift tax exemption is determined, some donors may not have a full $1 million exemption this year, but if they use the full exemption by the end of 2010, they can obtain a bonus exemption in 2011.
  • Opportunity for Gifts or Trust Distributions to Grandchildren. Some gifts or trust distributions to grandchildren (or similar younger-generation beneficiaries) can be made in 2010 without any generation-skipping transfer tax (GST tax).  Such gifts and distributions must be carefully structured to avoid GST tax in the future, however
  • Low Interest Rates May Not Last Much Longer. Interest rates have remained low this year, but they will eventually increase.  This year could be the best opportunity for the foreseeable future to use a leveraged techniquesuch as a grantor retained annuity trust (GRAT), an installment sale to a grantor trust, an intra-family loan (including refinancing an existing family loan), or a charitable lead annuity trust.
  • Converting to Roth IRA with Charitable Deduction to Offset the Tax. Conversion of a regular IRA to a Roth IRA in 2010 may provide substantial benefits for certain individuals, in particular those with sufficient liquid assets outside of the IRA to pay the tax.  The tax burden can be further reduced, or offset entirely, with substantial charitable gifts made this year.  The temporary sunset (for 2010 only) of the phase-out of itemized deductions (including charitable deductions) for high-income earners will allow those taxpayers to obtain a greater after-tax benefit from their 2010 charitable deductions.

Gift Tax Rates Will Increase in 2011

Due to political considerations, the 2001 estate tax act eliminated the estate tax for only one year—2010.  The gift tax was retained, even for 2010, primarily to avoid the loss of income tax revenue.  For 2010 only, the tax rate on gifts that exceed the $13,000 gift tax annual exclusion and the $1 million lifetime gift tax exemption isonly 35%.  This is a substantial discount from the 45% rate for 2009 and rates of up to 55% that will apply after 2010.

Persons facing substantial estate taxes who can afford to transfer assets and pay gift taxes now should give serious consideration to making gifts this year.  Gifts in 2010 should substantially reduce the total tax cost of transferring wealth to descendants and other beneficiaries as a result of four factors:

  • the lower gift tax rate for 2010;
  • the shift of future income and appreciation out of the taxable estate;
  • the potential for valuation discounts that often apply to gifts but not bequests of the same property; and
  • the potential to reduce the taxable estate by the amount of gift taxes paid if the donor survives the gift by three years.

This is illustrated by the three examples in the table on the following page, each involving a donor who has previously used his or her available gift tax annual exclusions and $1 million lifetime gift tax exemption.  The donor owns $10 million of other assets in addition to a controlling interest in a company, which would be included in the donor’s estate without valuation discounts (Example 1).  Examples 2 and 3 assume a gift of the interest in the company structured in a way that achieves valuation discounts for lack of marketability and lack of control.

It appears increasingly likely that Congress will not act in 2010 to retroactively impose a higher gift tax rate on gifts made previously in 2010.  However, to avoid that risk entirely, a gift could be set up in advance of the year-end and then executed in late December 2010 after the possibility of a retroactive rate increase disappears.  Other, more complicated alternatives can be structured to allow final decisions to be postponed into 2011.

Large gifts require some planning and implementation, especially if special entities are to be created and appraisals obtained to determine valuation discounts.  Consequently, it is important for donors interested in taking advantage of this opportunity to contact their advisors as soon as possible so that there is sufficient time to plan and implement the transfers.  Donors who wait until December may not have enough time to implement full and optimal strategies.

Gift Tax Exemption Available for Some Gifts Made in 2010–2011

The common understanding that there is a $1 million lifetime exemption from gift taxes in 2010 and 2011 is not exactly correct.  There are some modest but real variations in the way the gift tax exemption is determined in those years.  As a result, donors who used $500,000 or more of their exemption before 2010 do not have a full $1 million lifetime gift tax exemption in 2010.  However, those who use their full amount by the end of 2010 can obtain a small amount (up to $36,585) of bonus exemption in 2011.

For example, a donor who has made $1,000,000 of taxable gifts before 2010 will have no additional lifetime gift tax exemption in 2010, but will have another $36,585 of exemption in 2011.  On the other hand, a donor who had made $600,000 of taxable gifts before 2010 will have only an additional $394,386 (not $400,000) of lifetime gift tax exemption remaining in 2010, but if he or she makes a taxable gift of at least $394,286 in 2010, that taxpayer would have an additional $41,742 of exemption available in 2011.  In each case, careful calculations must be made to determine a donor’s remaining gift tax exemption for 2010 and the amount of taxable gifts that should be made in 2010 to obtain the maximum possible additional exemption in 2011.

Table:  Illustration of Benefits of Taxable Gifts in 2010

Description Example 1: Bequest in 2015  

Example 2: Gift in 2011

 

 Example 3: Gift in 2010
Value of property in 2010, before transfer

(transfer = by bequest or gift, as indicated)

 $10,000,000 $10,000,000 $10,000,000
Period of appreciation before transfer 5 years 1 year 0 years
Appreciation before transfer, at 5% per year $2,762,816 $500,000 (None)
Value at time of transfer $12,762,816 $10,500,000 $10,000,000
Valuation discounts (33%*) $0 ($3,465,000) ($3,300,000)
Value subject to transfer $12,762,816 $7,035,000 $6,700,000
Transfer tax type Estate Gift Gift
Marginal transfer tax rate 55% 55% 35%
Transfer taxes (estate or gift; federal and state combined) $7,052,689 $3,699,250 $2,345,000
Value of other estate in 2015** $10,000,000 $6,300,750 $7,655,000
Estate taxes on other estate $5,671,059 $3,682,200 $4,478,000
Net to beneficiaries *** $7,276,251 $8,919,300 $10,832,000
Cost of postponement compared to 2010 gift ($3,555,749) ($1,912,700) (None)
Effective tax rate **** 63.62% 45.28% 38.65%
*  Valuation adjustments for factors such as lack of marketability and minority interest are commonly in this range, but sometimes higher or lower.  A qualified appraisal should be arranged as part of the planning on the transaction.  This table’s Example 1 assumes that the interest is retained until death in a manner that does not qualify for valuation discounts.
**   Value of other estate = $10 million less gift taxes paid (Examples 2 and 3), plus value of other estate in 2015, less estate taxes on other estate
***  Net to beneficiaries = pre-discount 2010 value less transfer (estate or gift) tax, plus value of other estate in 2015, less estate taxes on other estate
**** Effective tax rate = tax ÷ (tax + net to beneficiaries)

Opportunity for Gifts or Trust Distributions to Grandchildren

In years before and after 2010, gifts or trust distributions to grandchildren (or similar younger-generation beneficiaries) were subject to a generation-skipping transfer tax in addition to any gift tax that might be due.  The GST tax is a flat tax at the top estate tax rate, and only applies after a lifetime exemption is fully used.  Because the GST tax is suspended for 2010, gifts or trust distributions this yearcan avoid that additional tax.  Such gifts and distributions must be carefully structured to avoid future GST tax, however.  Transfers to trusts or trust equivalents (including UTMA accounts) for the benefit of a grandchild will still be subject to GST tax when later distributed to the grandchild.  A direct transfer to a grandchild (including, we believe, a guardianship estate for a minor grandchild) will avoid the tax, both now and later.  Persons planning gifts or bequests to grandchildren should consider whether a gift this year might be more advantageous.  Trustees expecting future distributions to grandchildren of the trust’s donor should consider whether accelerating the distribution into 2010 would provide more of a tax advantage.  In both cases, an attorney  can help analyze whether and to what extent taking action this year would help.

Low Interest Rates May Not Last Much Longer

Interest rates remained low this year, but they will eventually increase.  We may never see a better opportunity to use leveraged techniques such as GRATs, installment sales to grantor trusts, intra-family loans (including refinancing existing family loans) and charitable lead annuity trusts.  A weighted average of Treasury rates is used to calculate the rates used in these wealth transfer techniques.  Once those rates increase, techniques that perform best with low interest rates will lose some of their advantage.  This would affect some of the most attractive wealth transfer techniques, all of which are described in prior newsletters:

  • GRAT:  a gift of future appreciation while retaining the present value of the transferred property
  • Charitable lead annuity trust (CLAT):  a gift of future appreciation while transferring the present value of the transferred property to charities of the donor’s choice
  • Installment sale to grantor trust:  a sale of appreciating property without immediate income tax consequences, with low interest rates and principal repayment in the future
  • Intra-family loan (including refinancing of a prior loan):  giving family members the benefit of lower interest rates than those available from commercial lenders

Because these leveraged techniques will be far more powerful while interest rates remain low, now is the time to put these techniques to work for you.

Converting to Roth IRA with Charitable Deduction to Offset the Tax

Starting with 2010, the income ceiling for conversions of regular IRAs to Roth IRAs was eliminated.  Conversion of a regular IRA to a Roth IRA in 2010 or 2011 can provide a substantial benefit for certain individuals, in particular those with sufficient liquid assets outside of the IRA to pay the tax.  Conversions in 2010 are generally more favorable than those postponed to 2011, both for a lower tax rate (under current law) and for the option to spread the additional taxable income over two years (2011 and 2012).

The tax burden of a Roth IRA conversion can be further reduced, or offset entirely, with substantial charitable gifts made this year.  Donors who have substantial charitable plans but do not wish to donate large amounts to independent charities in the current year could make substantial charitable gifts this year to a private foundation or donor-advised fund, from which those funds could be donated in turn to other charities over many years.  Private foundations and, to a lesser extent, donor-advised funds take some time to set up in time for gifts to be completed by year-end.  If this opportunity is of interest, donors should contact their advisors as soon as possible.

From 1990 through 2009, and again after 2010, high-income taxpayers (with $166,800 or more of adjusted gross income in 2009) lost up to the lesser of 3% of their AGI or 80% of their itemized deductions (including charitable deductions).  The temporary sunset (for 2010 only) of this reduction of itemized deductions will allow those high-income taxpayers to obtain a greater after-tax benefit from their 2010 charitable deductions.

To Reduce Tax Uncertainty, Plan Now, Execute in December

Some tax legislation in the 2010 post-election “lame duck” session cannot be ruled out, and the chances for tax legislation in early 2011 are even greater.  Unfortunately, the opportunities described in this Bulletin will generally have to be implemented by the end of 2010 to take full advantage of them.  Fortunately, the types of tax legislation that would most likely be passed in early 2011 will not remove the advantages of transactions completed in 2010.

Time for Action

Many of the opportunities described in this Bulletin have an absolute expiration date:  December 31, 2010.  Others may not be available much longer than that in this volatile economic and legislative environment.  Your advisors to identify the opportunities that are most relevant in your situation and implement them while the opportunities remain available.

FEDERAL TAX NOTICE:  Treasury Regulations require us to inform you that any federal tax advice contained herein (including in any attachments and enclosures) is not intended or written to be used, and cannot be used by any person or entity, for the purpose of avoiding penalties that may be imposed by the Internal Revenue Service.

© 2010 Vedder Price P.C.