Tennessee Estate Planning Law : Tennessee Estate Planning Lawyer & Attorney : Bryan Howard : Howard & Mobley Law Firm : Nashville, Chattanooga, Memphis

"This is the eighth article of a series designed to provide guidance for those individuals who are considering making a large gift in 2012 to take advantage of the $5.12 million federal gift tax exemption that will expire at the end of the year. For prior articles, see below.

The Revenue Reconciliation Act of 1990 curtailed various types of estate planning transactions that had been very effective during the 1980s. While curtailing these other types of transactions, the 1990 Act created two primary types of transactions that could be used to reduce estate taxes. These were grantor retained annuity trusts (GRATs) and Qualified Personal Residence Trusts (QPRTs).

QPRTs are relatively painless and very effective at reducing the value of your estate that will be subject to estate taxes. We have created dozens of these trusts for second homes located in other states. However, in 22 years, we have set up less than 20 of these for Tennessee residences. The reason is that our clients would have had to pay Tennessee gift tax in order to put their Tennessee homes into QPRTs. The recent elimination of Tennessee gift taxes now makes QPRTs for Tennessee residences very viable. Since May, several of our clients have established QPRTs or plan to establish them during the next seven weeks to take advantage of their $5.12 million of gift tax exemption in 2012. We expect to help our clients to establish more Tennessee QPRTs during 2012 than we established in the prior 22 years. For clients who have sufficient other assets that are gifting candidates, a QPRT may not be the most effective gift.

Part 1: Use It or Lose It

Part 2: Can You Afford to Make a Large Gift?

Part 3: When Should You Make the Gift?

Part 4: Will a Large Gift Demotivate Your Children?

Part 5: Tennessee Gift Tax Clawback

Part 6: Tennessee Gift Tax Clawback Solutions

Part 7: Life Insurance Can Pay Tennessee Gift Tax Clawback

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Steve Oshins, an attorney in Nevada, has compiled the first annual ranking of the best states for the creation of Dynasty Trusts. He ranks Tennessee as the fourth best state. Ironically, our high ranking is a tribute to our laws other than our rule against perpetuities. Approximately 20 states have totally repealed their rule against perpetuities, which means that trusts established under the laws of these states can last forever. Tennessee allows a trust to last for a maximum of 360 years. Certain trust companies located in these other states claim that Tennessee is a bad state for dynasty trusts, because a trust can only last 360 years. I have never talked to a client who cared whether the trust had to end after 360 years. Ask yourself this question: Do you even know the names of any of your relatives who were alive in the year 1652?

One of the reasons that Tennessee scores well despite our 360 year rule is because of our good spendthrift trust laws that protect assets from spouses of beneficiaries in the event of a divorce. This is not the case in a lot of other states. I think Mr. Oshins accurately determined that protecting trust assets in the event of divorce is substantially more important than being able to extend the life of a trust for more than 360 years. If assets are lost in a divorce, the trust is not going to last 360 years anyway.

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The Tax Relief Act of 2010 added a provision that allows a surviving spouse to use any unused estate tax exemption from his or her deceased spouse. So far, this is only available if both spouses die between January 1, 2011 and December 31, 2012. There is widespread optimism that portability will be extended by future legislation.

The IRS published regulations on June 15, 2012 dealing with numerous issues regarding the regulations. There are two noteworthy items that affect short-term planning.

First, if your spouse died on or after January 1, 2011, the rules for filing your spouse’s estate tax return have been relaxed under certain circumstances. If your spouse’s estate is not required to file an estate tax return because the value of the estate is below the filing threshold, you generally do not have to report values of assets passing to the surviving spouse or to charity. You only need to report the description, ownership, and/or beneficiary of the property together with sufficient information to establish your right to the marital or charitable deduction. This means that you are not required to obtain a full-blown appraisal of these assets. However, you must use “due diligence” to estimate the fair market value of the gross estate. You are allowed to identify a range of values with the Executor’s “best estimate” rounded to the nearest $250,000. This is welcome news because expensive appraisals can be avoided. You still have the issue of determining the fair market value of the assets for purposes of establishing the income tax basis of the asset and may choose to obtain appraisals anyway.

The other good news is that the regulations made it clear that gifts by the surviving spouse first use up the unused estate tax exemption from his/her spouse (“DSUE”). If your spouse died over the last eighteen months and left you some DSUE, you should consider making a gift prior to year-end. First, we don’t know that portability will be extended. Second, if you remarry and your next spouse dies before you have used your DSUE, you will lose the DSUE from your first spouse.

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Until 2004, it was very difficult to modify an irrevocable trust without going to court. That year, Tennessee adopted the Tennessee Uniform Trust Code which allows various changes to be made to irrevocable trusts without going to court.

Earlier this month, Christy Reid, from Charlotte, North Carolina, and I presented a paper on this topic. We discussed four tools for modifying trusts:  non-judicial settlement agreements, non-judicial consent modifications, decanting, and trust divisions. This is not the exclusive list of tools for making modifications. These are the tools that we use most often to help our clients improve the operation of their trusts.

While preparing for the presentation, I reviewed the laws of other states and concluded that Tennessee has the most flexible laws. I found a couple of places where our laws could be improved, and I will attempt to have these changes made.

It is also possible for judges to modify trusts. Sometimes, going to court is the only viable solution. We prefer to use a non-judicial method when available because it is less expensive for our clients and takes less time.

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A previous article detailed a case in which Edith Windsor had to pay $350,000 of federal estate taxes when her spouse died because Edith’s spouse was a woman rather than a man. The tax penalty was based on a 1996 federal law signed by President Clinton known as the Defense of [Heterosexual] Marriage Act (“DOMA”). The actual tax cost was significantly higher than $350,000 because New York also charged more than $200,000 of inheritance taxes that would not have applied if Edith’s spouse had been a man.

A federal judge in New York recently ordered the IRS to refund the federal estate taxes that were assessed. The judge ruled that DOMA is unconstitutional.

It appears that the constitutionality of DOMA will eventually be decided by the U.S. Supreme Court. Unless and until DOMA is thrown out, you should assume that gifts and bequests to your spouse will not qualify for a gift or estate tax marital deduction unless your spouse is a member of the opposite sex.

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This is the seventh article of a series designed to provide guidance for those individuals who are considering making a large gift in 2012 to take advantage of the $5.12 million federal gift tax exemption that will expire at the end of the year. For prior articles, see below.

Two prior articles discussed the Tennessee Gift Tax clawback issue. Last week, I met with a couple to establish a trust for their children. They plan to make a gift of $10.2 million to the trust later this summer. We discussed the Tennessee clawback issue and the potential solutions. The wife is seven years younger than the husband and does not have any major health issues. She will be making the entire gift. Even though this decreases the chances of the gift tax clawback from applying, there is still a chance that the wife could get run over by the proverbial beer truck.

We discussed the possibility of including a contingent marital trust that would make the husband a beneficiary of the trust if the wife dies within three years after making the gift. Since a primary purpose of the trust is to provide an asset base and income for their children, they did not like the option of the contingent marital trust.

We came up with a different solution. The trust will purchase a term life insurance policy on the wife’s life that can be dropped after three years. When the wife makes a gift to the trust, she will require the trustee to assume liability for any Tennessee inheritance taxes that are eventually imposed on the gift. If the wife dies within three years, the trust will collect life insurance and will be able to pay the additional Tennessee inheritance taxes.

          Part 1: Use It or Lose It

          Part 2: Can You Afford to Make a Large Gift?

          Part 3: When Should You Make the Gift?

          Part 4: Will a Large Gift Demotivate Your Children?

          Part 5: Tennessee Gift Tax Clawback

          Part 6: Tennessee Gift Tax Clawback Solutions

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The Tax Court recently ruled that gifts of family limited partnership interests qualified for the gift tax annual exclusion, which is currently $13,000 per donee per year. Estate of George Wimmer involved a family limited partnership that was funded with marketable securities. Mr. Wimmer made gifts of limited partnership interests to children and trusts for grandchildren. The IRS disallowed annual exclusions for the gifts which forced Mr. Wimmer's estate to sue the IRS in Tax Court.

As is typical with limited partnership agreements, the Wimmer limited partners could not freely transfer their interests to third parties. Because the partners could not sell their interests, the Judge required the partnership to satisfy three income tests: (1) the partnership would generate income, (2) some portion of that income would flow steadily to the donees, and (3) that portion of income could be readily ascertained.  Because the Wimmer FLP had predictable income and made regular income distributions to its partners, the Judge allowed annual exclusions for the gifts.

This case is welcome news for taxpayers. Two prior cases decided by the Tax Court, Hackl and Price, had ruled against the taxpayer. The partnership in Hackl did not make distributions and the partnership in Price made irregular distributions. At least for now, the Tax Court has established a rule that the limited partnership must make regular income distributions in order for gifts of limited partnership interests to qualify for the gift tax annual exclusion.

When you desire to transfer a limited partnership interest, an LLC interest or stock that is not making regular income distributions, you should be aware that the IRS may challenge your qualification for the annual exclusion. You should consider making taxable gifts or sales of these interests and using your annual exclusion to make gifts of cash or other income-producing assets.

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I just finished a project for a husband and wife who own commercial real estate with a fair market value of $10 million and a cost basis of $2 million. The husband is in poor health; his wife is 15 years younger and enjoys good health. The real estate was owned jointly by the couple when I met them in March.

I recommended that they transfer all of their real estate and other assets to a Tennessee Community Property Trust. Assuming the husband dies first, the real estate will obtain an income tax basis of $10 million upon his death. This will allow his wife to take significantly higher depreciation deductions with respect to the property following her husband’s death. Furthermore, in the event that she chooses to sell the property after her husband dies, there will be no capital gains taxes or depreciation recapture (except for appreciation and depreciation that occurs after her husband’s death).

If the husband had died before the trust was established, only one-half of the property would have received a stepped-up basis, resulting in an overall basis of $6 million rather than $10 million. Thus, transferring the property from joint ownership to a community property trust will result in an additional $4 million of basis upon the husband’s death.

In addition to the income tax benefit, there are two ancillary benefits of the community property trust. First, the husband will have $5.12 million of assets to fund his federal estate tax exemption if he dies this year. Second, probate will be avoided for both spouses.

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This is the sixth article of a series designed to provide guidance for those individuals who are considering making a large gift in 2012 to take advantage of the $5.12 million federal gift tax exemption that will expire at the end of the year. For prior articles, see below.

The last article explained a potential Tennessee inheritance tax problem if the donor dies within three years after making a large gift. The gift will be added back to your taxable estate for Tennessee inheritance tax purposes. This means that even though you paid no Tennessee gift tax on the gift, you will have to pay Tennessee inheritance taxes on the gift. The problem is most expensive if the donor dies before 2015.

We have come up with two potential solutions for married couples to avoid the tax. First, the healthier spouse can make the gift. If the healthier spouse makes the gift, you reduce the odds that the donor will die within three years. Assume that the healthier spouse makes a gift of $10,240,000 to a trust for your children. For federal gift tax purposes, you can elect gift-splitting and treat the gift as if it was made equally by the two spouses. If the less healthy spouse dies within three years, no portion of the gift will be added to their Tennessee inheritance tax base. On the other hand, if the healthier spouse dies within three years, he or she will have to add back $10,240,000 to his or her taxable estate for Tennessee inheritance tax purposes. This solution is not useful if the plan is for the healthier spouse to be a beneficiary of the trust (which we generally recommend). As a general rule, it will create federal estate tax problems upon the death of a donor if the donor makes a gift to a trust of which the donor is a beneficiary. A future article will explore an important exception to this problem.

The second solution for avoiding the Tennessee gift tax clawback is to make the gift to a trust that provides for a contingent marital trust.  The clause operates as follows: It says that if the donor dies prior to 2016 and any portion of the trust is included in the donor’s estate for Tennessee inheritance tax purposes, then the portion of the trust that is included will be moved to a trust that qualifies for the Tennessee inheritance tax marital deduction. In general, this means that your spouse will be the only beneficiary of the trust during his or her lifetime and must be able to withdraw all of the income earned by the trust during his or her lifetime.

It is not necessary to move the entire trust to the contingent marital trust; you only need to move the portion that is necessary to eliminate Tennessee inheritance taxes.  One option is to give an independent trustee the option to decide how much will be added back to the marital trust. There are also various types of formulas that can be utilized.

In effect, the contingent marital trust allows you to avoid Tennessee taxes if the donor spouse lives at least three years or the surviving spouse lives at least until 2016. Even if the surviving spouse does not live until 2016, there is some benefit if the surviving spouse dies in a later year. This is because the Tennessee inheritance tax exemption increases each year between now and 2016.

We have used contingent marital trusts in irrevocable life insurance trusts for years.  The federal estate tax and the Tennessee inheritance tax both include life insurance in the estate if the policy was transferred to the ILIT within three years prior to death. The contingent marital trust allows you to avoid taxes upon the insured’s death within three years.

The downside of the contingent marital trust is that the children will no longer be beneficiaries of the trust for the remainder of the surviving spouse’s lifetime. 

In summary, there are two options that increase the likelihood that married couples will avoid the Tennessee gift tax clawback. One is for the healthy spouse to make the gift. The second is to include a contingent marital trust in the donee trust. Neither one of these techniques will work in all circumstances. Furthermore, many donors no longer have a spouse or are not willing to include the spouse in the gifting plan (for example, someone in a second marriage when each spouse has children from prior marriages).

Since there is some danger of the tax applying, the donor should consider asking the donee to agree to pay the tax if tax does, in fact, apply. In theory, the donee’s agreement to pay the tax reduces the value of the gift at the time it is made. The problem is that it is difficult to value the liability that the donee is assuming. There is a good chance that the IRS will challenge any reduction that you try to make in the value of the gift due to the potential liability that the donee is assuming. In any event, the agreement to pay taxes is very important when your residuary estate will be distributed to beneficiaries who are different than the donee of the gift. Your residuary beneficiaries may not appreciate paying the clawback tax on gifts made to other beneficiaries.

          Part 1: Use It or Lose It,

          Part 2: Can You Afford to Make a Large Gift?,

          Part 3: When Should You Make the Gift?,

          Part 4: Will a Large Gift Demotivate Your Children?, and

          Part 5: Tennessee Gift Tax Clawback

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