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

Yesterday was a beautiful day in Nashville. Supposedly, that means we’re in for six weeks of miserable weather. Whether or not we receive all of this dreary weather, we expect the sun to be shining bright in spring and summer.

Like the groundhog, a lot of our clients are able to forecast future conditions for their businesses. We encourage our clients to consider their estate planning when conditions are still cloudy, but the future looks bright.

Yesterday, I met with a business owner whose business struggled during the Great Recession. The tide is beginning to turn, and my client believes the business will become very profitable in the next three to five years. Now is a great time for him to make gifts of company stock to a trust for his children. Due to poor earnings for the last three years, an appraiser will put a very low value on the stock. If the stock performs well in the future, the value of the stock will belong to the trust and not to my client. If the stock does not perform well, then my client will only have a modest estate tax problem. His real vulnerability to estate taxes is the possibility that the business will become very valuable while he still owns it.

Prior to making the gift, we will recapitalize the company stock so that 99% of the stock is non-voting and 1% is voting. My client will transfer all of his non-voting stock to a trust for his son and daughter, and he will retain all of the voting stock. This will enable him to control corporate policy, including the salary that he pays to himself. 

Gifts should be made when the future is uncertain, but there remains a possibility of sunny weather ahead. Apparently this is the technique that Mitt Romney used to establish a trust fund for his children that is now worth $100 million without paying any gift taxes. Mr. Romney must have given assets to the trust before they blossomed into full value. It is really quite easy to do as long as you are willing to make gifts before the business becomes valuable. There are numerous techniques for transferring assets in a tax efficient manner after they become valuable. None of these techniques are as good as making gifts before the assets become valuable.

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Citizens for Tax Justice has published an article which lists the number of residents of each state who paid estate taxes between the years 2000 and 2010. In 2000, there were 662 Tennesseans who paid estate taxes. This represented 1.2% of all the Tennesseans who died during the preceding year. This number gradually decreased during the following decade until only 40 Tennesseans paid taxes in 2010. This represented 0.1% of the Tennesseans who died in 2009.

The number of Tennesseans who will pay federal estate taxes in 2011 should be even less due to the one-year repeal of estate taxes for decedents dying in 2010.

Even though the number of estates paying federal estate taxes has declined, the number of estates paying Tennessee inheritance taxes has remained constant. Tennessee has not changed its estate tax laws since the 20th century. The Tennessee inheritance tax exemption is only $1 million. 

Citizens for Tax Justice advocates decreasing the estate tax exemption. It supports a proposal introduced by Congressman McDermott named “The Sensible Estate Tax Act of 2011.” This proposal would reduce the federal estate tax exemption from $5 million to $1 million per person.  Fortunately, noone expects this Act to be approved. 

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Unconfirmed rumors are circulating that the Super Committee may propose to reduce the current $5 million gift tax exemption to $1 million, potentially effective as early as November 23, 2011. It seems unlikely to me, but the rumor could be based upon “leaks” from insiders who are familiar with the Super Committee deliberations.

A lot of our clients have already made their $5 million gifts. Others are taking their time and studying their options. A couple of our clients who were studying their options are now mobilizing to complete their gifts prior to November 23, 2011. 

If you are concerned about a potential law change but will not be able to complete your gift by November 23, 2011, there is one technique that you should consider. An inter vivos QTIP trust would allow you to beat the law change, if there is one, yet provide you with the flexibility to unwind the transaction if there is no law change. Assume that Husband makes a $4 million gift to a marital trust that benefits Wife for her lifetime and then continues in trust for the benefit of their children. If the Super Committee does not change the law, and the gift tax exemption remains in place until December 31, 2012, the marital trust will be liquidated and the assets will be distributed to the wife. The couple will then decide how to best use their $5 million gift tax exemption. If this course is followed, Husband will need to file Tennessee and federal gift tax returns on April 15, 2012 (or October 15, 2012 with an extension), and make QTIP elections on both returns.

Alternatively, if the $5 million gift tax exemption is eliminated as of November 23, 2011, the QTIP trust will stay in place and the husband’s federal gift tax return for 2011 will not make a QTIP election.   The Tennessee gift tax return for 2011 will still make a QTIP election in order to avoid paying Tennessee gift taxes for 2011.

The QTIP plan will allow the husband to utilize his gift tax exemption but does not allow the wife to utilize her exemption. If the wife establishes a similar $4 million trust for the husband, there is a danger that the reciprocal trust doctrine will eliminate all of the proposed benefits from the transaction. In theory, the separate trusts for the husband and the wife can have different provisions that will avoid the application of the reciprocal trust doctrine. However, it is my opinion that there is still some risk if they each establish trusts that benefit the other, especially since the two trusts will be created very near in time to each other. Accordingly, I do not recommend the establishment of QTIP trusts by both spouses.

I am very skeptical about Congress closing the gift tax window as of November 23, 2011. Nevertheless, you might as well consider acting before that date if you are committed to making a gift anyway. An inter vivos QTIP trust is one method for hedging your bets.

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The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 authorized portability of the federal estate and gift tax exemption for married couples. This means that if one spouse dies without having used his or her entire exemption, the survivor may use it.

Portability has been widely hailed as a great estate planning benefit. The benefit is that the first spouse to die can leave everything to the survivor rather than having to create a credit shelter trust. 

Our view is that the benefit of portability is overrated; furthermore, it creates a trap for the unwary. We are not advising any of our married clients to plan on using portability.

The foremost reason that we do not favor portability is because the statute that created it also required the law to expire on December 31, 2012. President Obama and many members of Congress have indicated that they would like to extend portability beyond this sunset date; however, we have learned that it is foolhardy to plan on the assumption that future tax laws will be consistent with sensible statements made by politicians. 

Even if portability is made “permanent” by future legislation, there are many pitfalls to using portability. First, there is no inflation adjustment. For example, assume a married man dies this year and leaves his entire $5 million estate to his wife. When the wife dies, she will be able to use her husband’s unused exemption, but without any adjustment for inflation. If the husband had placed the $5 million in a credit shelter trust instead of transferring it to his wife, appreciation of the value of the trust during his wife’s remaining lifetime would have also escaped estate taxes.

The Tennessee inheritance tax exemption is not portable. If you fail to use the exemption in the estate of the first spouse to die, it will be lost forever. This will result in higher Tennessee inheritance taxes for the survivor’s estate.

Those who plan to establish trusts that last for the lifetimes of their children and beyond, are concerned about generation-skipping transfer tax exemption. The GST exemption is not portable. However, if the first to die establishes a trust and allocates GST exemption to the trust, the trust will be exempt from generation-skipping taxes for up to 360 years.

In order to claim portability, the estate of the first spouse to die must file a timely federal estate tax return. I predict that a lot of surviving spouses who are not otherwise required to file an estate tax return will fail to file timely returns in order to claim portability. 

There are numerous portability issues associated with the remarriage of the surviving spouse. It will likely take years for regulations and court cases to fully flesh out these issues. All things considered, we recommend that you disregard portability as a planning tool, at least until the law is made permanent.

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One year ago, I wrote about interest rates reaching an all-time low. They dipped a little more late last year, then increased before heading lower again. Now, they have reached another all-time low.

The 7520 Rate for transactions in October of 2011 will be 1.4%. This represents a 30% decrease from the September rate of 2%.  

Grantor retained annuity trusts (“GRATS”) and charitable lead annuity trusts (“CLATS”) work well when the Section 7520 Rate is low. Installment sales to grantor trusts and intra-family loans also work well when interest rates are low. These transactions use different interest rates than the 7520 Rate, but these rates are also near the all-time low.

One of my clients is currently evaluating a sale to a grantor trust in exchange for a private annuity. Private annuities work better in a low interest rate environment. I seldom recommend private annuities because they work best in terms of reducing estate taxes when my client dies sooner. This particular client is not expected to live beyond 3 years, though he has at least a 50% chance of living at least one year. This 50% threshold is required in order to use the IRS actuarial tables.

The low interest rate environment is not good for charitable remainder annuity trusts (“CRATS”) and qualified personal residence trusts (“QPRTS”). Even though low interest rates are not favorable for QPRTS, some of my clients are establishing QPRTs to take advantage of the current low values of residential real estate. One of my clients will be establishing two QPRTs for her Florida vacation home before the end of September in order to take advantage of the higher rates.

You should consider acting now to take advantage of the opportunities presented by the record low IRS interest rates and the $5 million federal gift tax exemption that is in effect for 2011 and 2012. 

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Everyone’s lifetime gift tax exemption increased significantly this year. Several of our clients who plan to take advantage of this opportunity have already made their $5 million gift.

Other clients are taking their time and considering their options before making their gift. Some have given $440,000 and plan to give the rest in 2012. The reason for a gift of $440,000 is because this is the amount above which the rate of Tennessee gift taxes increases from 7.5% to 9.5%. If you are planning to give more than $440,000, you should consider splitting the gift between 2011 and 2012 in order to minimize Tennessee gift taxes.

One of our clients has become concerned about the political rhetoric regarding a potential repeal of the Bush-era tax cuts for millionaires. To my knowledge, this rhetoric has not been specifically directed to the $5 million gift tax exemption. However, President Obama’s plan to reduce our deficit proposes a return of the estate tax exemption to 2009 levels in 2013. In 2009, the gift tax exemption was only $1 million.

If the President’s plan gains traction, it could be passed with an earlier effective date. There is some possibility, albeit remote, that the $5 million gift tax exemption will not stay in place until December 31, 2012.

Our client had planned to make a gift of $440,000 in 2011 and $4,680,000 in 2012. You will notice that the two gifts add up to $5,120,000. There is a CPI inflator on the $5 million gift tax exemption for 2012. The official number will be announced later this year; however, based upon inflation that has occurred to date, the exemption has been estimated to rise to $5,120,000 for 2012.

Our client has decided to reverse the gifts and make a gift of $4,680,000 in October of 2011 and $440,000 on January 1, 2012. Our client will still get the benefit of running up the Tennessee gift tax rate brackets twice. Our client is taking the risk that any change to the gift tax exemption that occurs during 2012 will not be made retroactive.

The one negative from accelerating the majority of the gift tax to 2011 is that our client will be required to pay the majority of the Tennessee gift tax on April 15, 2012, rather than April 15, 2013. Accelerating the payment of approximately $430,000 in gift taxes by one year will cost the interest that could have earned between April 15, 2012 and April 15, 2013. Since interest rates being paid on fixed-income investments are so low right now, our client has decided that accelerating the payment of the Tennessee gift tax is cheap insurance against a potential law change.

If you know that you want to make a $5 million gift prior to December 31, 2012, you should consider accelerating a substantial portion of the gift to 2011. In addition to hedging against a potential adverse law change, accelerating the gift could have other benefits. If you choose to make a gift of an asset with depressed values, such as real estate or stock, the asset might appreciate in value, which would enhance the value of the gift.

Other benefits from accelerating the gift include income from the property as well as your payment of income taxes on the income. Once you make the gift, income from the gift will belong to your donee. Almost all of our clients who are making large gifts are making the gifts to a grantor trust. This means that the donor will continue to pay income tax on the income from the gift even though they will not receive the income. Paying income tax on income that you do not receive further reduces your taxable estate.

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A previous blog discussed the Mitchell case, in which long-term leases substantially reduced the estate tax value of certain real property. A very significant issue did not have to be decided by the Court because the IRS stipulated that the property gifted by the decedent as well as the property still owned by the decedent at the time of his death would receive fractional interest discounts.

Six days before he died, Mr. Mitchell gave a 5% interest in his beachfront property and his ranch to a trust for his sons. The IRS stipulated before trial that the 5% gift of the beachfront property would receive a 32% fractional interest discount and the 5% gift of the ranch would receive a 40% discount.

The IRS also stipulated that the 95% interests in the beachfront property and the ranch that were owned by the decedent at the time of his death would receive fractional interest discounts of 19% and 35%, respectively.  The combined fractional interest discounts saved more than $1 million of estate taxes.

Numerous court decisions have recognized significant fractional interest discounts. In my experience, discounts of 25% to 35% are typical.  These court decisions influenced the decision by the IRS to concede the discounts in the Mitchell case.

The decedent’s revocable trust devised the 95% interest to the very same trust to which he had gifted a 5% interest just 6 days before his death. Therefore, the trust for the sons received a 100% ownership of the property. However, by dividing the transfer of the property to the sons’ trust into two separate portions, Mr. Mitchell significantly reduced his estate taxes.

Mr. Mitchell's estate was fortunate to receive the discounts since he made the gift after he became very ill due to cancer. Some prior cases have disallowed otherwise valid discounts for deathbed gifts. Ideally, the gift should be made at least one year before death and certainly before a diagnosis of a terminal illness.

Whenever you plan to make a gift of real estate, you should consider giving part now and part later (or part to one donee and part to another donee). Further, if you are planning to devise real estate through your Will, you should consider giving a small percentage interest in your lifetime and the remainder through your Will.  Now is an excellent time to make a gift due to depressed real estate values and the temporary $5 million federal gift tax exemption.

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In a recent case decided by the Tax Court, Estate of James L. Mitchell v. Commissioner, T.C.M. 2011-94, the Tax Court determined that the long-term leases on a ranch and home owned by the decedent significantly reduced the values of the properties. The home was subject to a 20-year lease. The value of the home without a lease was $14 million. The court determined that the value of the property subject to the lease was $6 million. This represents a 57% discount attributable to the lease.

The ranch was subject to a 25-year lease. The value of the ranch without a lease was $13 million. The value of the ranch with the lease was $3.37. This represents a 74% discount due to the lease.

One might think that the lease payments were below market. However, evidence presented at trial indicated that the rent charged with respect to both properties reflected market value. The significant decrease in value is attributable to the way properties subject to a long-term lease are valued. Appraisers value the stream of rental income payments plus the value that you could sell the property for after the lease term is over. This stream of payments is discounted by the rate of return that an investor would require to take over the stream of payments. Often, the discounted value of the stream of payments is lower than the value that you could sell the property for if the property did not have a lease.

The properties owned by Mr. Mitchell were somewhat unusual. A more typical circumstance is real estate leased to a family business. You should consider leasing the property for a long-term. 

After a long-term lease is entered into with respect to a property, you should consider some type of gifting transaction. Rental real estate works well for a direct gift, a GRAT, or an installment sale to a grantor trust.

In summary, if you have rental real estate that you intend for you and your family to own for several years, you should consider leasing the property for a long term. The lease can significantly reduce estate taxes upon your death.
 

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I recently met with clients who own a very valuable home in Florida. We discussed the potential use of a revocable trust to avoid the need for ancillary probate in Florida following their deaths. We subsequently discussed ideas for reducing their estate taxes, including the use of a QPRT for their Florida home. My clients decided to proceed with a QPRT, but decided not to use a revocable trust since it is not needed for avoiding Florida probate.

The wife is a few years younger and has no known health concerns; therefore, she is the better candidate to establish the QPRT. She will transfer one-half of the home to a QPRT with a 10-year term and one-half of the home to a QPRT with a 13-year term.

Using two QPRTs instead of one accomplishes two purposes: First, it allows a fractional interest discount for both halves of the house. This can be as much as 25 or 30 percent. Second, the mortality risk is hedged somewhat. If the wife dies after 11 years, she will have succeeded in removing one-half of the home from her estate. We are hoping that she survives at least 13 years and removes the whole house from her estate.

The combined GRAT discount and fractional interest discount amount to about 50% of the current value of the home. This means that my clients will be making a $2.2 million gift at the current time. There are no federal gift tax concerns due to the current $5 million federal gift tax exemption. Because the gift is Florida real estate, it will not be subject to Tennessee gift taxes. Thus, this asset is an ideal way to take advantage of the current high federal gift tax exemption without having to pay Tennessee gift taxes.

It is likely that the home will appreciate between now and the date of death of my clients. Assuming the wife lives at least 13 years, none of the appreciation will ever be subject to transfer taxes.

In summary, when you own a home in another state, you might consider using a QPRT to avoid ancillary probate and to reduce estate taxes.
 

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A lot of my clients own stocks in the healthcare industry. Many stocks in that industry have been battered the last three days, primarily due to concern over Medicare cuts.

I have one of my clients trained to recognize a dip in the market as a good time to establish a GRAT. He previously established 3 GRATs with 2 year terms. We started his first GRAT in the spring of 2008. As you might imagine, this GRAT did not perform well due to the collapse of the stock market. However, his other two GRATs are performing very well and will provide a lot of tax-free funds to his children, who will use the funds to repay loans made to them by their mother.

Recognizing that the significant decline in the value of his healthcare stocks creates a gifting opportunity, he called me today to initiate a fourth GRAT. Only time will tell whether this is a temporary price decrease or a prolonged decrease in the value of the stock. If the combined appreciation and dividends from the stocks exceed 2% over the next 2 years, his children will receive all of the excess.

The great thing about a GRAT is that if the stock goes up, your children win; if the stock stays even or goes down, all of the stock and dividends will be returned to you and your children do not lose anything.
 

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When my clients want to make substantial outright bequests, I encourage them to switch from an outright bequest to a trust with the beneficiary as the trustee.  The trust provides the beneficiary with creditor protection, divorce protection, and estate and inheritance tax protection.  Occasionally, I hear questions from my clients or their advisors concerning whether the trust will be included in the beneficiary/trustee’s estate for estate tax purposes.

The beneficiary can be a trustee of a trust for his or her benefit if distributions to the beneficiary are limited to an ascertainable standard, as defined by the IRS. The IRS definition of ascertainable standard is defined as health, education, maintenance, or support. If the purposes for which the beneficiary/trustee can make distributions are limited to these categories, the trust will not be included in the beneficiary’s estate upon the beneficiary’s death.

Occasionally, someone uses a slightly different standard and the IRS will attack the standard. In Estate of Ann R. Chancellor, T.C. Memo 2011-172, the decedent was a trustee and beneficiary of a trust that allowed corpus distributions for “necessary maintenance, education, healthcare, sustenance, welfare or other appropriate expenditures needed by the beneficiaries… taking into consideration the standard of living to which they are accustomed.” The IRS argued that this was not an ascertainable standard. The Court undertook an analysis of Mississippi law and determined that the standard was ascertainable. Therefore, the trust was not subject to estate taxes.

Even though the taxpayers won this case, they incurred stress and unnecessary legal fees due to the trust using language that did not track the IRS definition of an ascertainable standard. In my opinion, the more expansive language did not accomplish anything.

Tennessee law, as well as the law of most other states, has interpreted the phrase “health, education, maintenance, and support” to include expenditures to maintain the beneficiary’s standard of living to which they are accustomed. Therefore, expanding the distribution standard to refer to “accustomed standard of living” does not increase the purposes for which distributions can be made. However, the more expansive language may invite unnecessary IRS scrutiny.

If you are concerned that an ascertainable standard is too restrictive, you can also give the beneficiary the right to withdraw up to 5% of the trust per year for any reason. I recommend limiting the withdrawal right to one day each year. If the beneficiary dies on the day that you have chosen (typically December 31), 5% of the value of the trust will be included in the beneficiary’s estate. However, if the beneficiary dies on any other day during the year, the 5% withdrawal power will not cause any portion of the trust to be included in the beneficiary’s estate.

In summary, rather than leaving significant bequests outright, you should leave them in trust with the beneficiary as trustee. The standard for distributions should be limited to health, education, maintenance, and support. You should also give the beneficiary the right to withdraw up to 5% of the trust for any reason. If you follow these guidelines, your beneficiaries will thank you and you will avoid creating estate tax issues for your beneficiaries.

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A previous article discussed the subject of maintaining your original Will in a safe location. A related question is whether you should destroy prior versions of your Will.

There are at least two very good reasons for destroying prior versions of your Will. First, beneficiaries who received a greater bequest under a prior Will might see your prior Will and have their feelings unnecessarily hurt. Or worse, they may decide to challenge the later Will.

The second reason for destroying prior Wills is to eliminate potential confusion. One decedent whose Estate I represented left numerous holographic wills, some of which did not have a date. In addition to uncertainty over which Will had been executed last, there was some concern that he lacked testamentary capacity when he prepared some of his Wills. Beneficiaries who would have fared better under prior Wills were active participants in protracted litigation regarding his Estate. If prior versions of the Will had been destroyed, the beneficiaries who were eliminated by the latest Will would not have known that they had been named in previous Wills.

There is one circumstance where it is advisable to maintain the most recent version of your Will. If there is any potential that one or more persons will challenge your Will, maintenance of the prior Will may be helpful, especially if the challenger fared no better under the prior version of your Will. I have been involved in two lawsuits involving disinherited children where the prior Will was useful. The disinherited children claimed that their parent either lacked testamentary capacity, or was unduly influenced by their siblings to prepare a Will that disinherited the child. In both lawsuits, the decedent had instructed their attorney to hold on to the prior version of their Will. In both cases, the decedent had made a conscious decision to disinherit a child due to their disappointment with the child. These decisions had been made when there was no question about the parent’s legal capacity. The maintenance of the prior Will made it easier to ward off the challenge by the disappointed child. If the original of the prior Will had not been maintained, there would have been a strong presumption that the prior Will had been destroyed or revoked. Fortunately, the original of the prior Will was produced. Because the prior Will also disinherited the child, the court did not even need to consider the disinherited child’s claim.

In summary, if there is any potential of a Will challenge, you should consider instructing your estate planning attorney or another trusted advisor to maintain the original of your prior Will. You should give them instructions to produce the Will only in the event of a Will challenge. If there is no potential for a Will challenge, you should destroy prior Wills in order to avoid potential confusion and hurt feelings.
 

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This is the seventh article of a series dealing with the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (“Act”). For the first six articles, see:

Part 1 – Charitable IRA Rollovers
Part 2 – Estate Tax/Carryover Basis Election for 2010 Decedents
Part 3 – Temporary $5 Million Estate Tax Exemption
Part 4 – Temporary $5 Million Gift Tax Exemption: Use it or Lose It
Part 5 – Gifting Without Making Yourself a Pauper
Part 6 – Making Gifts Without Paying Tennessee Gift Taxes

Part 5 discussed methods for maintaining access to cash flow from gifted assets. Part 6 discussed methods for avoiding Tennessee gift taxes. This article will discuss a method for combining the concepts discussed in Parts 5 and 6.

A Tennessee QTIP Trust allows you to make a completed taxable gift for federal gift tax purposes without paying Tennessee gift taxes. The reason you do not pay Tennessee gift taxes is because the trust qualifies for the Tennessee gift tax marital deduction. This is not a new technique. We have been using it for 12 years. There has always been a difference between the federal gift tax exemption and the Tennessee gift tax exemption. However, due to the higher federal gift tax exemption, we plan to establish more Tennessee QTIP Trusts in 2011 and 2012 than all prior years combined.

Another appealing feature of a Tennessee QTIP Trust is the spouse’s access to cash flow from the trust. A lot of our clients would make no gift at all or would make a much smaller gift if they could not obtain access to cash flow.

Tennessee QTIP Trusts do not provide cash flow for your children.  If one of your objectives is to increase cash flow for your children, you should consdier other techniques, perhaps in conjunction with a Tennessee QTIP Trust.

In summary, if you would like to take advantage of the temporary $5 million federal gift tax exemption but are unwilling to pay Tennessee gift taxes or need to maintain indirect access to cash flow, you should consider establishing a Tennessee QTIP Trust.
 

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I highly recommend that my clients keep their original Will in their lockbox because the original must be located in order to probate the Will. It is possible to probate a copy of the Will. Generally, you can only probate a copy if no one objects.

If the first person to find your Will does not like its provisions, they might “lose” the Will because they will fare better if you do not have a Will. If the Will is lost, those who would have fared better will find it very difficult to overcome the presumption that the Will was revoked.

The attached case of two stepchildren against their stepfather, Janice Davis Boelter and Richard Davis v Jackie Curtus Reagan et al, demonstrates the problem. The decedent’s will gave her entire estate to her two children, leaving nothing for her husband (who was not the father of her children). After her death, her children were unable to find her Will, which had been executed 16 years prior to her death. The Will may have legitimately been lost. However, it is also possible that her second husband found the original Will and discarded it because he didn’t like its provisions.

Because the children were unable to locate the original Will, the estate was administered as if the decedent did not have a Will. This meant that the husband received a significant share of the Estate.

I have been involved in another case where a Will could not be found. There was a suspicion that the Will had been fraudulently destroyed by a person who had access to the decedent’s records after the decedent had become mentally incapacitated. No one could prove that the Will had been fraudulently destroyed because it is very difficult to prove a negative.

So what should you do with your original Will? Assuming you choose to keep your own original, you should put it in a lockbox and not allow those who would fare poorly under the Will to have access to your lockbox. Some of my clients leave their original Will with a trusted advisor such as a CPA, attorney or banker.  In addition to making sure that your original Will is retained in a safe location, you should periodically confirm that your original Will is still where you want it to be.

Another possible solution is to use a funded Revocable Trust as the document that disposes of your assets following your death. An original of your Revocable Trust does not need to be produced for any reason. A copy of the Revocable Trust will suffice to allow your successor Trustee to distribute the assets in the trust, even if the original cannot be located. 

The reason for having a Will is to make sure that your assets are distributed in accordance with your wishes.  It would be a shame for your plans to be thwarted due to a lost Will.
 

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This is the sixth article of a series dealing with the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (“Act”). For the first five articles, see:

Part 1 – Charitable IRA Rollovers
Part 2 – Estate Tax/Carryover Basis Election for 2010 Decedents
Part 3 – Temporary $5 Million Estate Tax Exemption
Part 4 – Temporary $5 Million Gift Tax Exemption: Use it or Lose It
Part 5 – Gifting Without Making Yourself a Pauper

Part 5 discussed methods for making gifts that do not decrease your cash flow. One significant blow to your cash flow could be Tennessee gift taxes. Tennessee does not have an exemption from taxable gifts. If you make a $5 million taxable gift, you will owe $463,400 of Tennessee gift taxes. A lot of our clients would be willing to make a significant taxable gift if they did not have to pay Tennessee gift taxes. This article will explain methods for avoiding or reducing Tennessee gift taxes.

Tennessee is one of only two states that impose gift taxes. Therefore, if you can arrange for the gift to be made by someone who is not a Tennessee resident, you can avoid paying Tennessee gift taxes. Several of our clients have either changed their residence to another state or are considering making this change.

Sometimes, one spouse has become a resident of another state, while the other spouse has remained a Tennessee resident. If the gift is made by the spouse who is not a Tennessee resident, no Tennessee gift taxes will be required. The gift by the non-Tennessee spouse can be split for federal gift tax purposes (this would allow a total gift of up to $10 million). Splitting the gift for federal gift tax purposes would not require the Tennessee non-donor spouse to file a Tennessee gift tax return.

Someone who is planning to move to Tennessee should make the gift prior to moving here.

The Tennessee gift tax does not apply to gifts from QTIP Trusts that were established by someone who was not a resident of Tennessee. This may be useful for someone who moved to Tennessee after a QTIP was established when they lived in another state. The beneficiary of the QTIP trust might be able to convey their interest in the trust to the remainder beneficiaries, thereby accelerating the vesting of the trust in the remainder beneficiaries.  If the QTIP Trust has a spendthrift clause, you will first have to modify the trust to eliminate this clause.

Tennessee gift taxes do not apply to gifts of real estate or tangible personal property that is physically located in another state. Our clients frequently take advantage of this exception by establishing Qualified Personal Residence Trusts for vacation homes located in other states.

It is much less common to deliver possession of tangible personal property while outside of the state. Assume that you want to give a valuable painting or piece of jewelry to a child. You and your child could drive to Bowling Green, Kentucky, and exchange the property while present in Kentucky. I recommend that you take a picture and perhaps prepare a contemporaneous memorandum that is witnessed by someone who is not a party to the gift transaction.

Tennessee gift taxes do not apply to gifts to 529 accounts. 529 accounts work best when the funds in the account will be used for college education expenses of the beneficiary. However, it is possible for the beneficiary to withdraw the portion of the account that is not needed for these expenses. When withdrawals are not made for qualified education purposes, federal income taxes and a penalty will be assessed on the income earned by the account.

If you plan to make a gift that requires you to pay Tennessee gift tax, you should consider splitting the gift between 2011 and 2012. If you split the gift between two years, this will reduce the overall taxes by $11,600. For example, if you make a gift of $440,000 in 2011 and a gift of $4,560,000 on January 1, 2012, your total taxes will be $451,800 rather than $463,400. Furthermore, the time for paying most of the tax will be postponed until April 15, 2013. Unlike income taxes, you are not required to make estimated payments throughout the year. 

Alternatively, you could reduce the gift on January 1, 2012 to $4,120,000. If the $5 million gift tax exemption is extended to 2013, you could make the final gift of $440,000 on January 1, 2013.  If the exemption is not extended, you would make the final $440,000 gift later in 2012.  Waiting gives you the opportunity to reduce taxes by another $11,600 if the higher gift tax exemption is extended.

When deciding whether to delay making a portion of your gift in order to reduce Tennessee gift taxes, keep in mind that the sooner you make the gift, the sooner you can get income and appreciation out of your estate.

Tennessee gift taxes are a serious concern for clients who want to take advantage of the 2 year opportunity to make large taxable gifts without paying federal gift taxes. There are various types of gifts that can be made without incurring Tennessee gift taxes.  If you must pay the taxes, splitting your gift between multiple years can soften the blow.

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This is the fifth article of a series dealing with the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (“Act”). For the first four articles, see:

Part 1 – Charitable IRA Rollovers
Part 2 – Estate Tax/Carryover Basis Election for 2010 Decedents
Part 3 – Temporary $5 Million Estate Tax Exemption
Part 4 – Temporary $5 Million Gift Tax Exemption: Use It or Lose It

The Act temporarily increases the gift tax exemption to $5 million for 2011 and $5 million increased by inflation for 2012. The Act decreases the gift tax exemption to $1 million for gifts in 2013 or later. Our clients are actively considering methods to take advantage of this 2 year window of opportunity to make large tax-free gifts.

The first commandment of gift planning is to take care of yourself. This article will explain techniques for taking advantage of the gift tax exemption without decreasing your cash flow below your comfort zone.

Valuable assets that do not provide much cash flow are good candidates for gifting. Typical examples are stock of a family business that does not declare dividends and real estate that does not generate income.

Personal residences can also be gifted. A Qualified Personal Residence Trust is the favored technique for gifts of a personal residence.

If you are married, you should consider making gifts to a spousal access trust and maintaining a good relationship with their spouse. Spousal access trusts allow distributions to be made to your spouse. Assuming that you can persuade your spouse to use distributions for the joint benefit of the two of you, this gives you indirect access to the trust assets. The flaw with this plan is that your spouse could predecease you. You might hedge this risk by purchasing life insurance on your spouse. Also keep in mind that your expenses will decrease after your spouse dies.

Spouses sometimes ask whether they can set up spousal access trusts for each other. This is dangerous due to the reciprocal trust doctrine. Careful design of the trusts can minimize, though not totally eliminate this risk. Due to the potential estate tax risk associated with reciprocal trusts, I encourage other alternatives.

We generally recommend that gifts be made to “grantor” trusts so that the donor can pay income taxes on the income of the trust. We design these trusts with an escape hatch so that the donor can cease paying taxes if the taxes become too much of a burden. The most common power that we use to make the trust a grantor trust is a power of substitution that allows the donor to swap assets with the trust as long as the swap has equivalent value. Assume that you give a high income asset to a spousal access trust and your spouse predeceases you. You could use the power of substitution to swap low income assets such as undeveloped land for cash in the trust or for the income producing property.

We frequently recommend gifts of non-voting stock in a corporation, non-voting units of an LLC, or limited partnership interests in a limited partnership. Generally, the donor and/or spouse maintain voting control of the entity that is being gifted. By maintaining voting control, they determine who runs the company and a reasonable salary to be paid to the managers of the company. Assuming the donor still participates in management, the company can pay the donor a reasonable salary.

One of our favorite gifting techniques involves a gift combined with an installment sale to a grantor trust. The trust will have an obligation to make payments to your over time. Your continued access to cash flow through note payments makes it more feasible to give assets to the trust.

Another popular gifting technique is a grantor retained annuity trust. These trusts allow you to receive payments from the trust for a period of years.

To this point, I have discussed gifts of non income producing property and methods for obtaining access to cash flow from property gifted to a trust. Other techniques reduce expenses that you would otherwise have to pay, which has the same effect as if you had maintained access to the cash flow.

One type of gift that relieves an expense is a Charitable Lead Trust. Assume that you plan to give at least $50,000 per year to charity for the next 10 years. If you make a gift to a Charitable Lead Trust that pays $50,000 to charity for 10 years, this will reduce the funds that you would otherwise have to spend for the charitable donation. Charitable Lead Trusts represent a fantastic opportunity for leveraging your gift tax exemption, especially when the amount going to charity does not increase.

Another technique for reducing your expenses involves the “leapfrog” (also referred to as “decanting”) power under the Tennessee Uniform Trust Code. The leapfrog power allows a trustee of one trust to make distributions to another trust that benefits the same beneficiaries. Assume that you previously established a life insurance trust (“ILIT”) that requires premium payments of $30,000 per year. If you make a gift to another trust that benefits the same beneficiaries, the trustee could distribute income from the new trust to the ILIT to enable it to pay life insurance premiums. The donor cannot ensure this result because the donor must give up all control over the gift. However, trustees generally can be counted on to assist with an overall plan that helps the beneficiaries of the trust.

There are several methods of taking advantage of the $5 million federal gift tax exemption without decreasing your cash flow. You can give away non income producing property. Some techniques provide cash flow directly to you or your spouse. Others reduce your expenses.
 

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This is the fourth article of a series dealing with the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (“Act”). For the first three articles, see:

Part 1 – Charitable IRA Rollovers
Part 2 – Estate Tax/Carryover Basis Election for 2010 Decedents
Part 3 – Temporary $5 Million Estate Tax Exemption

The Act temporarily increases the gift tax exemption to $5 million for 2011 and $5 million increased by inflation for 2012. For example, if inflation for 2011 is 2%, the gift tax exemption will be $5.1 million in 2012. The Act decreases the gift tax exemption to $1 million for gifts in 2013 or later.

In addition to increasing the gift tax exemption, the Act set the maximum gift tax rate at 35% for 2011 and 2012. The Act increases the maximum gift tax rate to 55% for 2013 and future years.

The temporary nature of the higher gift tax exemption provides an incentive to make gifts in 2011 and 2012. If you choose not to make gifts and then die in a year when the estate tax exemption is lower than $5 million, you will pay significantly more estate taxes than if you made the gift. Assume for example, that an individual who currently has $6 million of assets dies on January 1, 2013. If he makes $5 million of gifts on or before December 31, 2012, his estate will owe $550,000 of estate taxes based on current law. If he makes $1 million or less of taxable gifts, he will owe approximately $2.6 million based on current law. Thus, making gifts can reduce taxes by as much as $2,050,000. Furthermore, income and appreciation occurring after the date of the gift will be removed from your estate, which increases the reduction in estate taxes.

Some commentators believe that the IRS may attempt to “clawback” as much as $1,385,000 of these tax savings if you die in 2013 or later. The analysis is confusing because you have to make calculations by pretending that the law in prior years was different than it really was. Nevertheless, I do not think the law permits a clawback. Even if a clawback were permitted, making gifts will still yield a substantial reduction in estate taxes.

Many of our clients have already begun to take advantage of the higher gift tax exemption. Several others are evaluating different strategies for taking advantage of the additional exemption.

The simplest method is a straight gift. Due to the current economic environment, a number of our clients have made loans to their children. Some of them are forgiving the loan obligations now that this can be done without federal gift tax consequences.

While a direct gift can be very effective, we often encourage our clients to leverage their gift by transferring a “discounted” asset. Good examples are non-voting stock in a family corporation or limited partnership interests in a limited partnership, or fractional interests in real estate.

We generally recommend that gifts be made to a grantor trust. This enables the donor to continue to pay income taxes on income earned by the trust and to further decrease his or her estate.

Some of our clients want to take advantage of the gift tax exemption yet are concerned that they will run out of cash in their later years. Fortunately, there are some gifting strategies that allow the donor to maintain access to cash flow. These strategies will be discussed in a future article

I am predicting that Tennessee gift tax collections will set all-time records on April 15, 2012 and again on April 15, 2013. Tennessee allows annual exclusion gifts just like the IRS. However, Tennessee does not have any exemption from gift tax. Therefore, you will generally pay Tennessee gift taxes when you make taxable gifts to take advantage of the higher federal gift tax exemption. In a future article, we will discuss methods for making gifts that do not require you to pay Tennessee gift taxes.

In summary, the $5 million federal gift tax exemption creates a two year opportunity for decreasing the size of your taxable estate. If you choose not to take advantage of this opportunity, your children will pay more federal estate taxes unless the law is changed. Some methods of utilizing the exemption allow you to maintain access to cash flow. There are also methods for making gifts that do not require the payment of Tennessee gift taxes.
 

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This is the third article of a series dealing with the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (“Act”). For the first two articles, see:

Part 1 – Charitable IRA Rollovers
Part 2 – Estate Tax/Carryover Basis Election for 2010 Decedents

The Act temporarily increases the estate tax exemption to $5 million for 2011 and $5 million increased by inflation for 2012. For example, if inflation for 2011 is 2%, the estate tax exemption will be $5.1 million in 2012. The Act decreases the exemption to $1 million for people dying in 2013 or later.

The Act set the maximum federal estate tax rate at 35% for 2011 and 2012, but increases the maximum rate to 55% for 2013 and future years.

The Act is great news for individuals who die in 2011 or 2012. Very few will owe federal estate taxes. However, the huge increase in estate taxes for people dying in 2013 makes estate planning tricky. Earlier this week, I met with a couple whose estate tax liability will increase from $2.9 million under 2011 law to $9 million if the survivor dies in 2013 or later. A large portion of their net worth involves a family business. They have sufficient liquid assets to pay for the 2011 taxes, but not the 2013 taxes. Should they make gifts to try to reduce estate taxes? Should they buy life insurance to provide liquidity to pay the taxes? It is possible that the $5 million exemption and 35% rate will be extended by future legislation. However, it is dangerous to make plans based on hoped for tax decreases to be enacted in the future.

Tennessee has not changed its exemption from inheritance tax. Tennessee’s exemption is still $1 million. Having different exemption amounts for Tennessee inheritance taxes and federal estate taxes is a matter that we have grown accustomed to since 2001. Most married couples deal with the disparate exemptions by transferring $1 million to a traditional credit shelter trust and transferring the difference between the federal exemption and the Tennessee exemption ($4 million under current law) to a Tennessee QTIP Trust. The Executor will make a Tennessee QTIP election for the Tennessee QTIP Trust, but will not make a federal QTIP election. This will ensure that no Tennessee taxes will have to be paid at the first death. Taxes will be payable with respect to the Tennessee QTIP Trust upon the surviving spouse’s death. However, there will not be any federal estate taxes imposed upon the Tennessee QTIP Trust upon the surviving spouse’s death.

Fortunately, most of the revocable trusts and wills that we have prepared for our clients have formulas that adjusted to the new estate tax exemption so that no changes are necessary. There is a very subtle change that we will recommend for people who otherwise need to amend their documents.. Even though it may not be necessary to amend their documents, married couples may need to rearrange ownership of certain assets. Each spouse should have $5 million of assets titled in their name so that the couple will be able to take full advantage of the higher estate tax exemption regardless of which spouse dies first.  A Tennessee Community Property Trust is a good method for dividing assets between the spouses.

The Act has a portability option which allows the surviving spouse to take advantage of any unused estate tax exemption of the first spouse to die. In theory, the portability option makes it unnecessary to rearrange ownership of assets and to fully fund the estate tax exemption of the first spouse to die in a credit shelter trust and/or Tennessee QTIP trust. As drafted, the portability option is a Trojan horse. We will explain in a future article why we do not recommend planning to take advantage of portability.

In summary, the higher estate tax exemption and lower estate tax rates will significantly reduce estate taxes for individuals dying in 2011 and 2012. There is some rearranging that may need to occur in order to take full advantage of the additional exemption.
 

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As my clients age, I am more likely to encourage them to establish a revocable trust. There are several reasons for this preference.

First, if my clients become incapacitated, it is easier for the successor trustee to manage my client’s assets in their capacity as Trustee. Experience has shown that financial institutions are more suspicious of powers of attorney than revocable trusts. Second, if my client is successful in changing the title of all of his/her assets to the Trust, probate can be avoided in Tennessee.

Third, if my client owns property in another state, probate can be avoided in the other state. Fourth, my elderly clients are less likely to acquire additional assets during their remaining lifetimes. Thus, it is more likely that they will be able to keep all of their assets titled in the name of their trust. Finally, my elderly clients have a keener appreciation of the privacy afforded by a revocable trust.

I am currently establishing revocable trusts for two of my clients who are approaching their 80th birthdays. During the last few years, the husband has become incapacitated due to Alzheimers. Fortunately, when he signed his Will in 2006, he also signed a durable general power of attorney which authorized his wife to establish a revocable trust for him. She may only exercise this power if the dispositive provisions of the revocable trust after the husband’s death are consistent with his Will. This means that she will not be able to change the manner in which his assets will be distributed.

The wife is making a change to her dispositive provisions. She is changing the bequest to her son from an outright disposition to a bequest in trust. She would like to make the same change to her husband’s revocable trust and is confident that he would approve of this change if he was able. However, she does not have this power under the power of attorney. If the husband dies first, his assets pass to two separate trusts that will benefit the wife during her lifetime and will give her a testamentary limited power of appointment over the trust assets upon her death. Therefore, if the husband dies first, the wife will be able to change the son’s bequest from her husband to a trust. She would have this power under his current Will; therefore, she is not changing anything that would otherwise happen if her husband did not change from a Will to a revocable trust.

After the wife signs the revocable trusts, she will change ownership of various assets to the trusts. This will allow probate to be avoided for both clients, will simplify the management of the assets during my clients’ remaining lifetimes, and will simplify the disposition of my clients’ assets following their deaths.

If you choose to use a Will to dispose of your estate, consider signing a power of attorney that gives your agent the ability to create a revocable trust for you after you become incapacitated.  This can make it easier to manage your assets during your remaining lifetime and simplify the dispositon of your assets following your death.   

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Jeff Mobley prepared the attached summary of estate, inheritance and gift tax facts. The chart provides various exemptions and rates under federal law and Tennessee law for 2011 and future years.

As you will see from the chart, Tennessee law is very stable. Federal law has another significant change occurring in less than 24 months.

I would like to vote for politicians who will pass stable, predictable, tax laws. When I voted last November, I was unable to find any federal politicians in this category.  

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Last week, the attorneys in our firm gave a presentation to the Nashville Society of Financial Service Professionals titled "The New Estate & Gift Tax Laws - The 2-Year Window of Opportunity.” The presentation was a joint effort by Bryan Howard, Jeff Mobley, Stephanie Edwards, and our two newest members, Paul Hayes and Paul Gontarek, who joined us at the beginning of the year.

Paul Hayes is an experienced estate planner like the rest of us, and is also a CPA and a Certified Financial Planner.

Paul Gontarek specializes in trust and estate litigation, which seems to be a growth industry due to  increased life expectancies and other societal changes.
 

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This is the second article of a series dealing with the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (“Act”). For the first article, see: Part 1 – Charitable IRA Rollovers

The Act retroactively reinstated estate taxes to apply to decedents who died in 2010. However, the Act provided two relief provisions. First, the federal estate tax exemption for 2010 decedents was $5 million. Second, the Act allows executors to elect the carryover basis regime for 2010 decedents if that regime is preferable to the estate tax regime.

We represent several estates that plan to elect the carryover basis regime. The carryover basis regime may result in future income taxes; however income taxes are less than estate taxes. Most estates of $10 million or more will elect the carryover basis regime. This is because the estate tax regime would result in estate taxes, either now or upon the death of the surviving spouse. Estates of unmarried decedents with more than $5 million will generally elect the carryover basis regime.

Estates worth $5 million or less will stay with the estate tax regime. They will not owe any federal estate taxes and all assets owned by the estate will receive a stepped-up basis.

The Executors for married decedents whose estates were between $5 and $10 million will have to analyze the two regimes. When the available basis step-up of $4.3 million is enough to increase the basis of all assets to date of death value, the estate should elect the carryover basis regime. When the basis step-up is not enough to eliminate all pre-death gains, the executor will need to analyze whether future income taxes to be incurred on pre-mortem appreciation will be more than future estate taxes to be incurred upon the death of the surviving spouse.

The analysis of future income taxes and future estate taxes requires a crystal ball. Income taxes might be avoided if the surviving spouse gives appreciated assets to charity or holds them until death. Estate taxes might be avoided if the surviving spouse makes sufficient gifts or if the $5 million federal estate tax exemption is extended until the year of the spouse’s death.

The Act did not specify how or when to make the election to be subject to the carryover basis regime. The Act specified that the Form 706 for decedents subject to the estate tax regime does not need to be filed until September 17, 2011. I expect guidance from the IRS clarifying that the carryover basis election can also be made as late as September 17, 2011.

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Late last night, the House of Representatives approved the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010. The Senate has already approved the Act and the President is expected to sign the Bill into law.

The Bill is almost all good news for taxpayers. The only bad news is that the tax reductions will only last through the end of 2012.

After 9½ years of waiting for changes to the estate and gift tax laws, we start a new two year waiting period. I wonder if there will ever again be a Bill which “permanently” reduces taxes without a sunset after some period of years.

There are several year-end planning opportunities that you can now take advantage of without worrying about whether this Bill will be enacted. Hats off to Congress for giving us two full weeks to plan during the holiday season.

If you have been waiting on selling depreciated stocks to harvest losses in 2010, you might as well pull the trigger because the losses will not be more valuable in 2011 than they are in 2010. Your broker will thank you for acting before Christmas rather than after Christmas.
 

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On December 15, 2010, the Senate passed the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 by a vote of 81-19. The Bill’s fate now rests in the hands of the House of Representatives. If the Bill is enacted as drafted, there are a few transactions that will be treated more favorably if they are completed during 2010.

1. Gifts to grandchildren are treated more favorably in 2010 because you do not have to allocate Generation Skipping Transfer Tax exemption to the gift. However, if you are making a taxable gift and you have already used your $1 million federal gift tax exemption, you should wait until next year when the gift tax exemption increases to $5 million.

2. Transfers to grandchildren from non-exempt trusts are not subject to GST tax in 2010. In general, this is advisable when the trust will be subject to GST tax upon the child’s death and the child has other resources.

3. Gifts to children should be postponed until next year in order to benefit from the increased gift tax exemption (from $1 million to $5 million).

4. Due to income tax rates staying the same in 2011 and 2012, you should evaluate making a Roth IRA conversion in December of 2010 as compared to January of 2011. If you make the conversion this year, you will be able to pay the income taxes from the conversion as follows: 62.5% on April 15, 2012, 12.5% on June 15, 2012, 12.5% on September 15, 2012, and 12.5% on January 15, 2013. You will have the ability to recharacterize the conversion until October 15, 2011. Alternatively, if you make the conversion in January, 2011, you must pay 100% of the tax on April 15, 2012. However, you will have the ability to recharacterize the Roth IRA to a regular IRA until October 15, 2012. As a general rule, the ability to recharacterize the conversion for the longer time period is more valuable than the ability to postpone 37.5% of the tax for a few extra months. Therefore, I am advising my clients to wait until January unless they expect material appreciation of their IRA between now and January.

5. Those of you who are at least 70½ years of age will be able to distribute up to $100,000 of the required minimum distribution from your IRA to charity. You should compare this option with the Synthetic Charitable IRA Gift technique which can be used even if the Bill does not pass or if you are younger than 70½.

The recommendations herein are dependent upon the Bill getting passed substantially in the form approved by the Senate. If the Bill does not get passed in its current form, these planning recommendations will need to be revisited. Stay tuned, and try to keep your options open for last minute planning.
 

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The Senate Finance Committee has released the text of the proposed bill to make various tax changes that were agreed to by President Obama and Republican Congressmen earlier this week.

On the income tax front, the bill would extend all of the so-called “Bush” tax cuts for two years and provide a two year fix for the alternative minimum tax.

There is a one year payroll tax reduction that will reduce the employee’s share of the payroll tax by two percentage points, from 6.2% to 4.2%.

Numerous tax “extenders” will apply for 2010 and 2011. These extenders include the deduction for state and local sales taxes and the charitable IRA rollover of up to $100,000 for individuals who are at least 70½. Apparently, if you fail to make a charitable gift in 2010, you will be able to double up and give up to $200,000 in 2011.

On the estate tax front, estate taxes are reinstated for decedents dying in 2010. However, there is an election for 2010 decedents to be subject to the carryover basis regime rather than the estate tax regime. The estate tax exemption is increased to $5 million per person and the top estate tax rate is capped at 35% for decedents dying in 2010, 2011, and 2012.

The estate tax exemption will be portable between spouses. To the extent the first spouse to die does not use his or her full exemption, it may be used by the surviving spouse if the surviving spouse dies before December 31, 2012 (or if this law is later extended).

The gift tax exemption will increase from $1 million to $5 million for 2011 and 2012 with a maximum rate of 35%. This 2 year increase in the gift tax exemption will create numerous planning opportunities.

GST exemption is increased to $5 million. Gifts to grandchildren in 2010 will not be subject to GST tax. 2010 distributions from non-exempt trusts to grandchildren will not be subject to GST tax. Several of my clients have already taken advantage of this opportunity. Others have been waiting for confirmation of this opportunity from this tax bill.

The overall revenue impact of the bill is estimated to be $860 million over the next three years.

There is uncertainty as to whether the bill will get enacted. Therefore, it would be prudent to wait a week or so before pulling the trigger on a year-end transaction that might be impacted by this bill

I will provide more details about the proposed legislation, especially about year-end planning opportunities, in future articles.
 

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James Gooch and I recently made a presentation to the Tennessee Federal Tax Conference. The title of our presentation was “Estate Planning Fixes.” We discussed solutions to problems that can arise with respect to Life Insurance Trusts, Family Limited Partnerships (“FLPs”), Grantor Retained Annuity Trusts (“GRATs”), Qualified Personal Residence Trusts (“QPRTs”), Charitable Remainder Trusts (“CRTs”) and Uniform Transfers to Minors accounts.

Planning for the presentation caused me to realize how much time I spend helping clients to improve prior estate planning arrangements. The good news is that there are lots of tools available to fix problems. Furthermore, more transactions are being structured with “escape hatches” that allow modifications to accommodate changed circumstances. 

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The IRS does not assess federal estate taxes on bequests to a spouse. However, when the wife of Edith Windsor died, Edith had to pay $350,000 of federal estate taxes. If Edith’s spouse had been a man instead of a woman, the estate taxes would have been zero. I do not know Ms. Windsor, but suspect that she would consider $350,000 to be an acceptable toll charge for being married to a woman rather than a man.

Edith had to pay estate taxes because the Defense of Marriage Act (“DOMA”) defines marriage as a union between one man and one woman. Edith and her wife lived in New York, whose laws considered them as spouses because they had been legally married under Canadian law.

The ACLU has filed suit on behalf of Edith against the U.S. government claiming that charging Edith $350,000 because her spouse was a woman rather than a man violates the U.S. Constitution. Edith claims that DOMA interferes with the rights of states to define marriage and violates the Constitution’s equal protection clause.

Some federal courts have already ruled that DOMA is unconstitutional. Other courts have upheld DOMA’s constitutionality. Eventually, the U.S. Supreme Court will decide this issue.
 

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One of my clients recently told me a story about a waylaid inheritance. In the 1980s, my client’s grandparents left an inheritance of $500,000 to my client’s mother. The grandparents loved their son-in-law and were not concerned that their daughter might die before their son-in-law and leave her inheritance to the son-in-law. In fact, the daughter died in 1993 and left her entire inheritance to her husband.

The daughter’s husband remarried in 1997. His second wife was stricken with cancer. He used all of his assets, including those that he had inherited from his first wife, to pay for medical expenses associated with his second wife’s cancer. When the son-in-law later died, he was virtually penniless. The bottom line is that the inheritance from the grandparents was used to pay for health care expenses of a woman whom the grandparents never met.  I doubt this is what the grandparents would have wanted.

Should this be written off as a case of bad luck, or was it a case of poor planning? There were two opportunities to create a different result that would have worked out better for the grandchildren. First, the grandparents could have established a trust for the daughter’s inheritance. Since they liked their son-in-law, the trust could have provided that the son-in-law would continue to receive income if he survived the daughter. Alternatively, the trust could have given the daughter the power to specify that her husband would receive all or part of the trust income following her death. The ultimate beneficiaries of the trust would be the grandchildren.
 

After the grandparents failed to establish a trust, their daughter could have established a trust for the primary benefit of her husband, with the remainder passing to her children. In either case, the principal of the trust would not have been available to pay for health care expenses of the second wife, and the grandchildren would have eventually received the principal of the trust.

Neither the grandparents nor the daughter anticipated that the son-in-law would get remarried and use the funds for the benefit of his second wife. Trusts should be used for significant inheritances to guard against unanticipated circumstances.
 

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A member of the House of Representatives from Wyoming has been told by some of her constituents that they are taking steps to die in 2010. Apparently, these individuals are willing to die early to make sure that their children will not pay estate taxes.These individuals are planning to discontinue taking dialysis and other life-extending medical treatments to increase the chance that their deaths will occur in 2010.

When the 2010 estate tax repeal was passed in 2001, it was dubbed by some as the “Throw Momma from the Train Act” due to the huge estate tax increase that will be incurred by the estates of wealthy individuals who die after 2010. There is still hope that the tax increase will be delayed or moderated. Unless and until the law is fixed, you should decline any invitations to take a year-end train ride or cruise with your children.
 

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I have noticed that a lot of my wealthy clients are uneasy about their financial situation. The values of their marketable securities are lower. The value of their real estate is lower. Their income is lower.

The attached article by Robert L. Moshman published in the Wealth Strategies Journal explores the plight of a hypothetical family that had a $20 million net worth prior to the recent recession. The article gave me a better understanding of why my clients with a net worth of $10 million or more are feeling so uneasy.

Clients with an 8 figure net worth have a significant estate tax liability. Low values, coupled with low interest rates, are a fantastic opportunity for various gifting strategies that can significantly reduce the future estate tax liabilities. However, because my clients are uneasy about “turning loose” their assets, I am recommending different gifting strategies.

The most popular strategies that I have used recently involve Spousal Access Trusts, Installments Sales to Grantor Trusts, and GRATS. All of these techniques allow the client (and/or the client’s spouse) to benefit from the property utilized in the gifting strategy, while reducing the value of the client’s estate for estate tax purposes. I am not planning on this shift being temporary. The emotional scars from the 2008 recession will profoundly affect the attitudes of wealthy Americans for years to come.

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I occasionally update estate planning documents for clients who move to Tennessee from a community property state. There are 9 community property states, including Texas, California, Arizona, Washington, Idaho, Louisiana, Nevada, New Mexico, and Wisconsin. The other 41 states are known as common law states.

I am currently updating estate planning documents for clients who recently moved from Arizona to Tennessee. As is so often the case with clients in community property states, these clients utilized a joint revocable trust as a centerpiece of their estate plan. I am amending their joint revocable trust so that it qualifies as a Tennessee Community Property Trust.

The assets that were in the trust at the time of the move were already community property. The amendment was not needed to qualify the prior assets as community property. However, additional assets that my clients acquire would not otherwise qualify as community property. By qualifying the trust as a Tennessee Community Property Trust, the additional assets will also qualify for community property benefits.

When clients do not already have a joint revocable trust at the time of their move, they have 2 choices for preserving the community property status of their assets acquired while married in the community property state. They can either create a Tennessee Community Property Trust and transfer the assets to the trust or they can sign a Community Property Agreement which documents the community property assets at the time of the move. The trust has the advantage of creating community property status for later acquired assets.

Community property is a valuable benefit that should be maintained when moving to a common law state. A Tennessee Community Property Trust is the preferred method for preserving this benefit.
 

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One of my clients called me today with a complaint about his Tennessee Class B Gift Tax. In 2009, he made a gift of $13,000 to his step-granddaughter. She had a tough year, including losing her job and getting divorced. $13,000 is the amount of the annual exclusion for federal gift tax purposes and Tennessee gift tax purposes for certain donees.

As a general rule, gifts that do not exceed the annual exclusion are exempt from gift tax. The problem is that Tennessee categorizes some donees as “Class B” beneficiaries. Class B beneficiaries consist of step-grandchildren, sisters-in-law, brothers-in-law, nieces, nephews, as well as persons who are not related to you.  Tennessee only allows you to make an annual exclusion gift of $3,000 per Class B beneficiary or $5,000 if you only make a gift to one Class B beneficiary.

Because my client’s step-granddaughter was the only Class B beneficiary to whom he made a gift, he owed tax of 6.5% times $8,000, or $520. My client was chapped because he was being “punished” for being generous to his step-granddaughter. In 2010, his gift to his step-granddaughter will only be $5,000.

Most people characterize the Class B gift tax as a silly tax. I suspect that it brings in less than $50,000 per year to the State. There have been numerous proposals to abolish the Class B distinction so that tax-free gifts of $13,000 can be made to anyone. Every time that a proposal is made, a fiscal note is attached to the bill and it never goes anywhere due to the fiscal note.

If you are making gifts to collateral relatives, you should consider limiting the gift to $3,000 per donee, or $5,000 if you are only making gifts to one Class B donee during the year if you want to avoid the Class B gift tax.

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Certain estate planning transactions are sensitive to interest rates that are established each month by the IRS. The interest rates, in turn, are based on market interest rates for debt obligations issued by the U.S. Government.

One rate that is used for several estate planning transactions is known as the Section 7520 Rate. The 7520 Rate for transactions in October of 2010 will be 2%. This ties the all time low (February, 2009) in the 21 year history of the 7520 Rate.

October will be a fantastic month for transactions that work well when the Section 7520 Rate is low. These transactions include grantor retained annuity trusts (“GRATS”), charitable lead annuity trusts (“CLATS”), installment sales to grantor trusts, and intra-family loans. Installment sales and loans use different interest rates than the 7520 Rate, but these rates are also near the all-time low.  If you already have an intrafamily loan, you should consider refinancing the loan in October.

The low interest rate environment is not good for charitable remainder annuity trusts (“CRATS”) and qualified personal residence trusts (“QPRTS”). Even though low interest rates are not favorable for QPRTS, some of my clients are establishing QPRTs to take advantage of the current low values of residential real estate.

Higher estate taxes are on the way in January and you should consider acting now to take advantage of the opportunities presented by the record low IRS interest rates.

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Estate planning for owners of intellectual property such as literary works has always been challenging. Copyright laws are complex. Maximizing financial returns from the property is heavily dependent on proper “marketing.”

History abounds with high profile court battles that are fought long after the death of the creator of the intellectual property. One such case, which is described in the enclosed article by Robert L. Moshman in the Wealth Strategies Journal, involves the works of the author Franz Kafka. His works were most recently fought over in an Israeli court earlier this year. He died in 1924. As stated in the article “everyone associated with Kafka ignored his requests.” He undoubtedly has rolled over in his grave several times.

Intellectual property rights can create significant estate tax problems. In my experience, the estate tax problems are secondary to proper management of the property rights following the creator’s death. At a minimum, proper planning requires knowledge of estate planning and intellectual property laws, an industry expert, and a sophisticated executor. The article mentions the idea of a literary executor, who would typically be an industry expert. Using a literary executor is a good idea, though it failed miserably for Edgar Allen Poe due to his poor selection of the literary executor.

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Some people mistakenly assume that their Will controls the disposition of all of their assets. There are several ways that your assets pass to someone outside of your Will.

Assets that are owned as tenants by the entirety with your spouse or joint with right of survivorship will pass to the other owner or owners by operation of law.

A large number of assets pass by beneficiary designation. Common examples are bank accounts, retirement accounts such as 401(k) plans and IRAs, and life insurance. See the enclosed article from Fidelity regarding important considerations in your choice of beneficiary designation.

If you transfer ownership of your assets to a trust before you die, the trust will dictate how the assets pass upon your death. A number of my clients have transferred all or a portion of their assets to a revocable trust or an asset protection trust.

Under Tennessee law, your spouse is entitled to elect against your Will and receive a share of your estate, year’s support, exempt property, and homestead. As a general rule, your spouse will elect to receive these benefits when they are better than the Will.

Even if your Will does not direct your Executor to pay your debts, your creditors will file claims against your estate and will be paid prior to the beneficiaries named under your Will.

Even if your Will does not direct your Executor to pay your tax obligations, the IRS and the State of Tennessee have priority over the beneficiaries of your Estate regarding the payment of income, inheritance, estate and generation-skipping transfer taxes, including interest and penalties. They have a “secret” lien against all of the assets of your Estate. If the Executor of your Estate fails to pay your tax obligations, the IRS and the State of Tennessee will be able to collect taxes from your Executor (to the extent that the Executor has distributed assets to the beneficiaries) or from the beneficiaries of your Estate (to the extent that they received assets from your Estate or from other methods such as beneficiary designations).

Because there are so many ways to receive assets that are not dependent on the terms of your Will, it is very important to make sure that you account for all of these potential non-testamentary transfers when planning for the disposition of your assets.

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I came across an interesting article regarding estate planning for second marriages. The article highlights some of the most common issues faced by male business owners who have children from a prior marriage. Women, of course, face many of the same issues.

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 I currently represent an 88 year old widower whose wife died less than 9 months ago. The wife’s estate is approximately $1.6 million. The husband’s assets, including a $1 million brokerage account that had been owned jointly with his wife, are worth approximately $1.8 million. Because the husband’s estate exceeds $1 million, his estate will owe more than $300,000 of estate taxes if he dies after January 1, 2011 and Congress does not change the tax laws prior to his death.

In an effort to reduce or eliminate his potential federal estate tax liability, I have recommended a disclaimer of the husband’s one-half survivorship interest in the brokerage account. If the husband chooses to file a disclaimer, his children will receive one-half of the brokerage account now, rather than following his death. Under federal law, the disclaimer will not be treated as a gift by the husband. This means that no federal gift or estate taxes will be charged on the $500,000 passing to his children.  The disclaimer will reduce his federal estate taxes by more than $200,000.

Tennessee treats a disclaimer of a joint brokerage account as a gift. The husband will have to pay $36,000 of Tennessee gift tax on April 15, 2011. Upon the husband’s death, the inheritance taxes imposed on his estate will be reduced by $36,000 as a result of the disclaimer. Therefore, the net effect of the disclaimer is to accelerate the payment of $36,000 from 9 months after the husband’s death to April 15, 2011.

The husband has a modest lifestyle and feels comfortable that he will have sufficient assets for his remaining lifetime after he executes the disclaimer. He also likes the idea of getting assets to his children sooner.

If we knew that Congress would change the federal estate tax exemption to $2 million or more prior to the husband’s death, it would be unnecessary to make the disclaimer. Unfortunately, the disclaimer must be filed within 9 months after the death of the wife. Congress has been in a stalemate for more than 9 years regarding the “estate tax fix.” Because the 9 month deadline will occur in a few weeks, the husband will have to make the disclaimer decision prior to finding out whether Congress changes the law.

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 In less than 6 months, federal estate taxes are scheduled to return with an exemption of $1 million and a maximum rate of 55%. Numerous bills have been submitted to provide relief from these taxes. Most of the bills would increase the exemption to $3.5 million or more and decrease the top rate to 45% or less.

These bills have not passed because they would significantly decrease tax revenues. The latest such failure was an amendment offered to a Jobs Bill by Senators Jon Kyl of Arizona and Blanche Lincoln of Arkansas. Apparently the Senate decided against combining a large tax decrease with a bill that proposes to increase spending by $33.9 billion.

A lot of Senators are hesitant to pass another large spending bill. Many of these same Senators believe that taxes, including estate taxes, should be reduced. In the enclosed LA Times article, Tennessee’s Lamar Alexander explained why it is logical to support decreasing taxes while at the same time fighting increasing spending as follows: “If you’re going to spend more, you have to have a revenue source or you run up the debt.” Reducing taxes "reduces the amount of revenue we have to spend, and we should reduce spending by the same amount.”

What Lamar says by implication is that the national debt will increase if you reduce taxes without reducing spending. There appears to be a lot of support for reducing taxes. There does not appear to be a lot of support for spending less. It will be very difficult to solve the estate tax dilemna if the fix requires a commitment to decrease spending. I am counseling my clients to be prepared for the return of federal estate taxes in 2011 with the $1 million exemption and 55% top rate.

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 It is very typical for a Will to direct the Executor to pay the Decedent’s valid debts. When my clients own real estate encumbered by a mortgage, they often want the successor owner of the real estate to continue paying the mortgage. For these clients, I place a provision in their Wills giving the Executor the discretion to continue paying the mortgage until the successor owner takes over the payments.

When the successor owner of the real estate is also the residuary beneficiary of your estate, it may not matter whether your estate or the successor owner pays the mortgage. If your estate pays the mortgage, the residuary estate passing to the successor owner will be less. Nevertheless, it provides more flexibility for the successor owner if you allow the mortgage to remain in place. The successor beneficiary can pay off the mortgage early if there is not a need to maintain the mortgage.

Things are not as easy when the successor owner of the real estate is not the residuary beneficiary of your estate. Now it makes a big difference as to whether your estate or the successor owner pays the mortgage.

If you decide that you want the successor owner to pay the mortgage, there is another consideration. The bank may file a claim against your estate and require the Executor to pay the mortgage. Depending upon whether the successor owner was jointly liable on the debt, your estate may have a claim against the successor owner to pay at least a portion of the debt. If you do not want your Executor to be in the position of having to sue the successor owner of the house, you should condition any bequest to the successor owner on their agreement to assume the mortgage. If you take this approach, the bequest to the successor owner will be reduced to the extent, if any, that your estate is required to make payments on the mortgage.

There are 2 methods by which the successor owner can acquire the property.

First, when you own the property, your Will simply devises the property to the successor owner. You can make the devise conditional on the devisee’s assumption of the mortgage.

Alternatively, when you own the property as tenants by the entirety with your spouse or jointly with right of survivorship, the successor owner will acquire the property by operation of law. Your Will cannot require the successor owner to assume the mortgage. However, if your Will makes a bequest of other assets to the successor owner, this bequest can be conditioned upon the successor owner’s assumption of the mortgage. If the bequest is less valuable than the mortgage, the successor owner might forfeit the bequest rather than assume the mortgage.

In summary, you need to decide who you want to pay your mortgage and draft your Will accordingly.

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One of my clients has been diagnosed with a rare disease that will very likely end her life in 2010. Due to the peculiar estate tax laws that apply to decedents dying in 2010, there are some unusual planning steps that my client and her husband are taking.

As a general rule, you want to make sure that the first spouse to die has sufficient assets titled in their name so that they can take maximum advantage of federal and Tennessee estate and inheritance tax exemptions. In 2009, the magic number was $3,500,000. This year, the amount is unlimited.

We previously split assets between the husband and the wife with each of them owning assets worth approximately $6 million. The husband is in the process of transferring most of his assets to his wife.

Another change that we are making is to create a revocable trust for the wife that will replace her will. The wife’s revocable trust will own her assets so that it will be unnecessary to probate her will. The revocable trust will transfer $1 million to a typical credit shelter trust of which the husband and children are beneficiaries. The remaining $11 million of assets will be transferred to a marital trust for the husband’s sole benefit during his lifetime. Assuming the wife dies when there is no federal estate tax, it will not be necessary to claim a marital deduction for the marital trust for federal estate tax purposes. We will elect to qualify for the marital deduction for Tennessee inheritance tax purposes so that no Tennessee taxes will be owed.

The overall result of this plan is that all of the couple's assets are eligible for a basis step up. Since the combined built-in appreciation of their assets is $4 million and there is $4.3 million of basis step up available, they will receive a full basis increase. Since they own some significant rental properties, the higher basis will increase the husband’s depreciation deductions.

More importantly, the $11 million marital trust will not be subject to federal estate taxes upon the husband’s subsequent death. This will be a tremendous advantage to the family if they do not ever have to worry about paying federal estate taxes.

In summary, simple planning steps are needed to take full advantage of the absence of federal estate taxes in 2010.
 

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One of the sad things about my profession is that my clients eventually die. Some deaths are sudden and unexpected, but most deaths occur after an accident or illness that makes death imminent within a few days or perhaps a few weeks. Though I am sensitive to the feelings of grief and stress that my clients and their families are experiencing, I have the unpleasant task of explaining to my clients and their families the heavy penalties they will pay to the federal and Tennessee governments if they decline to take advantage of “last minute” tax reduction opportunities.

I am currently working with one of my clients who has been given a life expectancy of 2 months or less. Because my client is likely to die in 2010, some of the planning issues are unique. However, some of the planning opportunities are the same as they would be for a death in a different year. Some of the major issues we have considered:

1. Make sure all assets are owned by the Revocable Trust so that probate can be avoided. My client has done an excellent job of funding her revocable trust. However, she recently loaned some money to a friend and the Note is payable to her rather than her trust. We are doing a simple assignment of the Note to make sure that it is owned by her trust.
2. Make annual exclusion gifts of $13,000. My client is making gifts of $13,000 to all of her children and grandchildren, as well as to spouses of her children. At a minimum, this will reduce Tennesse inheritance taxes. If federal estate taxes are reinstated with an effective date prior to the date of my client’s death, or, if she survives until 2011, the gifts will also reduce federal estate taxes.
3. My client is converting her IRA to a Roth IRA.
4. My client’s revocable trust makes charitable bequests totaling $500,000. My client trusts her children to make these gifts. Therefore, she is amending her trust to give the money to her children. The children will pay Tennessee inheritance taxes on this bequest at the rate of 9.5%. However, they will receive charitable income tax deductions which will reduce their federal income taxes by approximately 35%. Furthermore, two of the children live in states with state income taxes. The charitable bequests will also reduce state income taxes. This plan will backfire if federal estate taxes are reinstated retroactively. If this were to happen, federal estate taxes would be higher than the income tax savings. In order to account for this possibility, the revocable trust will provide that if the children disclaim the bequest, then the bequest will go to the charities. This will allow the children to see what happens over the next nine months before they must decide whether to disclaim.
5. Should appreciated assets be sold to avoid losing the benefit of a capital loss carryover? Fortunately, no sales are necessary, because the carryover basis law that applies for decedents dying in 2010 allows the unused capital loss carryover to be added to the $1.3 million basis increase. My client’s executor will have more flexibility to avoid future capital gains if the capital loss carryover is preserved.
6. Finally, my client is researching her records regarding her income tax basis for several assets. She can find this information much more easily than her Executor.

Estate planning when death is imminent can reduce taxes and other problems. Even though the circumstances are unpleasant, the potential benefits are substantial. I have been told by some of my former clients and/or their families that they took comfort in their final days from the knowledge that financial matters were in good shape.
 

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A recent article discussed the use of Inter Vivos Marital Trusts to reduce estate taxes. These trusts can also be used to provide asset protection from future creditors. When the objective is asset protection, the trust is designed differently.

One spouse transfers property to a trust for the benefit of the other spouse. If the donee spouse predeceases the donor spouse, the donor spouse becomes the beneficiary of the trust. The donor spouse’s retention of a successor beneficial interest in the trust represents the key distinction of a marital trust that is used for asset protection rather than reducing estate taxes.

This type of trust has always been exempt from future creditors during the donee spouse’s lifetime because it is a third party created spendthrift trust. When the donor spouse becomes the beneficiary, the trust has traditionally been available to all creditors of the donor spouse since the transfer was made to a trust of which the donor is a beneficiary.

A new Tennessee law will make these trusts exempt from the donor spouse’s future creditors after July 1, 2010. This means that one spouse can transfer substantially all of his or her assets to a trust and protect the assets from future creditors of both spouses.

Inter Vivos Marital Trusts may not be used to avoid the donor’s obligations to creditors that already exist at the time of the transfer to the trust. If the donor spouse does not retain sufficient assets to pay existing creditors, the preexisting creditors can attack the trust as a fraudulent conveyance.

Another potential benefit of an Inter Vivos Marital Trust is to make sure that the donee spouse has sufficient assets to utilize his or her federal estate tax exemption and Tennessee inheritance tax exemption. This will reduce estate taxes upon the surviving spouse’s death. No gift taxes will be payable if the donor spouse files timely federal and Tennessee gift tax returns which make a QTIP election.

For federal income tax purposes, the donor spouse will be taxed on all of the taxable income of the trust, including capital gains, during his or her lifetime. The donee spouse will be taxable on the ordinary income of the trust following the death of the donor spouse and may be taxed on some or all of the capital gains of the trust.
 

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I recently met with a couple for whom I prepared Wills in 2006. They want to make a change to their Will because a member of their family died unexpectedly. When they went to their lockbox, they were unable to find their original Wills. Fortunately, they still have the ability to sign new Wills.

What would have happened if one of my clients had died and the survivor was unable to find the Will? It is likely that we could have probated a copy of the Will. Tennessee law allows a Court to probate a copy of the Will when there is credible testimony that the Will has been lost and that there was no intention to revoke the Will. I have successfully probated copies of Wills on 6 or 7 occasions. Every time that I have probated a copy, no one objected and a close family member was able to give credible testimony about the Will being lost.

You should assume that your heirs will be unsuccessful in probating a copy of your Will. When the original Will cannot be found, there is a strong presumption under Tennessee law that the Will was revoked. There have been numerous cases where the Court refused to probate a copy of a Will. If the Court refuses to probate the copy, the Court will choose an administrator to manage your estate and distribute your assets according to the intestate succession laws of Tennessee.

Due to the problems caused when your original Will cannot be located, it is very important that you keep your original Will in a lockbox or other safe location. You also need to make sure that one or more trustworthy persons knows the location of your original Will.

Revocable trusts do not have the same problem. The Trustee does not have to produce the original Trust Agreement in order to carry out its duties. This is another potential benefit of a revocable trust.
 

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Short-term capital gains are taxed at a significantly higher rate than long-term capital gains. In 2010, the maximum rates are 35% for short-term capital gains and 15% for long-term capital gains. In 2011, the maximum rates will increase to 39.6% and 20%.

Prior to 2010, gains from sales of assets by an estate were automatically treated as long-term capital gains, regardless of when the decedent bought the asset. For decedents dying in 2010, this rule does not apply. It is now necessary to determine when the decedent bought the asset. If the asset is sold within a year after it was acquired, the gain will be short-term.

Tax on pre-mortem gain can be eliminated by allocating the decedent’s basis increase to the property. Every decedent has $1.3 million of basis increase that may be allocated by the Executor. Married decedents potentially have an additional $3 million of basis increase that can be allocated.

The basis increase can not be used to eliminate post-mortem gains. Assume the decedent bought a stock for $200,000 on November 1, 2009. The decedent died on March 31, 2010 when the stock was worth $260,000. If the Executor sells the stock for $300,000 on October 15, 2010, there will be a short-term capital gain of $100,000. The pre-mortem gain of $60,000 can potentially be eliminated if the Executor chooses to allocate a portion of the decedent’s basis increase to this particular asset. The basis increase cannot be used to wipe out the $40,000 post-mortem gain.

The gain could be converted from short-term capital gain to long-term capital gain if the Executor waits to sell until November 1, 2010.

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Making a lifetime gift of the $1,000,000 federal gift tax exemption amount can substantially reduce estate taxes. Appreciation and income from the gifted property between the date of the gift and the donor’s death can escape federal transfer taxes. My clients are generally unwilling to make such a gift because it would require the payment of Tennessee gift taxes. A second problem is that the donor loses access to the income from the gift.

A Tennessee QTIP Trust™ provides an opportunity for making a lifetime gift without paying Tennessee gift tax while retaining indirect access to the income through your spouse. A Tennessee QTIP Trust™ is a trust that would qualify for the federal gift tax marital deduction but for which the donor elects not to make a QTIP election on the federal gift tax return. The donor does make the QTIP Trust election on the Tennessee gift tax return.

The Tennessee QTIP Trust must make income available to the donee spouse. Rather than requiring income to be paid to the spouse, the spouse should be given the right to withdraw income. There are two benefits from using the right to withdraw income as opposed to the mandatory payment of income. First, to the extent that income accumulates in the trust, it will escape federal transfer tax. The second benefit is that either the donor spouse or the donee spouse will be required to pay federal income taxes attributable to trust income even though the income remains in the trust. Thus, the trust is able to grow in value on a pre-tax basis.

The donor spouse should not have a successor life estate or discretionary principal interest following the death of the donee spouse. This would cause estate tax inclusion for the donor spouse.

The downside with a Tennessee QTIP Trust occurs when the donee spouse predeceases the donor spouse. If the value of the trust upon the donee spouse’s death exceeds the $1,000,000 Tennessee inheritance tax exemption, the donee spouse’s estate will pay Tennessee inheritance tax. This means that some transfer tax will be paid prior to the death of the survivor. Because the lifetime Tennessee QTIP Trust will exhaust the donee spouse’s Tennessee inheritance tax exemption, the donee spouse’s Will should establish a testamentary Tennessee QTIP Trust (as opposed to a traditional credit shelter trust) for the donee spouse’s federal estate tax exemption amount.

Due to the potential Tennessee inheritance tax upon the death of the donee spouse, and the necessity of the donee spouse’s establishment of a testamentary Tennessee QTIP Trust, it may be advisable for the spouse with the shortest life expectancy to be the one who establishes the lifetime trust. Access to income will also be preserved if the survivor is the donee spouse. Nevertheless, the greatest benefit from accelerating the use of the federal gift tax exemption will occur if the trust is established by the spouse with the longest life expectancy.

A Tennessee QTIP Trust™ can reduce estate taxes while allowing the donee spouse to retain access to the income and corpus of the trust.

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I recently read that 43% of the 91,000 babies born in Tennessee in 2008 were born out of wedlock. Babies with unwed parents are now so common that the social stigma from yesteryear has largely disappeared.  Nevertheless, there are still circumstances where the law discriminates against children born out of wedlock.

When someone dies without a Will, the state of Tennessee decides who will inherit the person’s estate. The laws governing this process are known as "Intestate Succession." When the decedent has no surviving spouse or descendants, the property is distributed to the decedent’s parents or descendants of the parents if they are deceased, i.e., brothers, sisters, nieces and nephews. If the parents are deceased and have no then living descendants, then the property is distributed to descendants of the decedent’s grandparents (i.e. aunts, uncles, first cousins, second cousins, third cousins). Children born out of wedlock frequently claim to be a member of the class who inherits from an intestate decedent.

The Cleo Snapp case is the most recent of several Tennessee cases that have treated children born out of wedlock as creditors of the estate. Tennessee law requires creditors to file a claim against the estate within 1 year of the decedent's death if they want to receive a share of the estate. Furthermore, if the executor notifies the creditor that they need to file a claim, they have only 4 months after receiving the notification. If the creditor does not file a timely claim, they forfeit their share of the estate.

The problem presents itself when inheritance rights flow through the potential inheritor's father. There is no requirement for filing a claim when your “blood” relationship to the decedent is through your mother.

When a potential inheritor files a timely claim, he or she must still prove the identity of their father by clear and convincing evidence.

The paternity issue most often arises when there is not a Will, but can also arise when there is a Will which does not clearly specify who inherits the decedent's estate.

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Qualified Personal Residence Trusts significantly reduce estate taxes that will be assessed on a personal residence. For married couples, I often recommend that the husband and wife each transfer a 50% interest in the residence to separate QPRTs. When both spouses establish separate trusts, you hedge the mortality risk associated with QPRTs. The other benefit from separate QPRTs was demonstrated by the recent Ludwick case in which the husband and wife each transferred 50% of their $7 million Hawaiian home to a separate QPRT. The court ruled that the value of each 50% interest was 17% less than 50% of the value of the entire home. The 17% fractional interest discount significantly reduced the gift tax cost of establishing the QPRTs.

There is also a way to take advantage of fractional interest QPRTs when it is not possible or practical to establish separate husband and wife QPRTs. One person can establish two separate QPRTs with different terms, for example, 6 years and 8 years, and transfer a 50% interest to the two separate QPRTs.

My clients seldom establish QPRTs for their Tennessee residences because they do not want to pay Tennessee gift taxes. Therefore, most QPRTs that my clients establish are for vacation homes located in other states. Generally, QPRTS in other states do not generate any federal or state gift taxes.

If you are buying an expensive home in Tennessee or elsewhere, there is a technique called a joint purchase trust that can be used without any gift taxes having to be paid. Joint purchase trusts have a lot in common with QPRTs. However, they must be established prior to purchasing the home.

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The term “dynasty trust” refers to a trust that will last for several generations. Since 2007, Tennesseans have been able to establish dynasty trusts that can last for 360 years. Prior to 2007, trusts had to terminate after approximately 100 years.

In order to qualify for the longer duration, the trust must provide a testamentary limited power of appointment to at least one member of each generation of your descendants who dies more than 90 years after the trust is established. A testamentary limited power of appointment provides the beneficiary with the right, through a provision in his or her Will, to terminate the trust in favor of certain beneficiaries or charities or to keep the property in trust with different provisions. Tennessee’s law is unique in requiring this power of appointment in order to qualify for the longer term.

The required power of appointment will be eliminated for trusts established on or after July 1, 2010. Even though the power of appointment will no longer be required, I still recommend that you provide future generations with the ability to modify the trust.  Imagine that your great great grandparents had established a trust in 1910 which now benefits you. Could they have possibly anticipated all of the changes that have occurred over the past 100 years and determined a sensible trust design for your descendants? It is much more likely that you can design a better trust to accommodate the specific attributes of your children and grandchildren and numerous changes that have occurred in the world over the last century.

If 360 years is not long enough for you, there are several states that allow trusts to last into perpetuity. Even if you live in Tennessee, you can take advantage of the laws in one of these other states. To date, only one of my clients has not been satisfied with 360 years.
 

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Over the past 6 trading days, the Dow Jones Industrial Average has dropped from 11,167 to 10,380, which is a drop of 7.6%. If you have not already converted your IRA to a Roth IRA, this is a golden opportunity to make the conversion.  By converting now, you might lose the opportunity to convert at the bottom if the market drops further. However, if it turns out that this is merely a temporary correction, you will be glad you made the conversion even if you slightly miss the bottom. If this turns out to be the beginning of a bear market, you can recharacterize your Roth IRA to a traditional IRA and try again next year. The recharacterization option lets you “win” if the market rebounds and “break even” if the market goes down further.

A market correction is also a good opportunity for establishing a GRAT. GRATs are similar to Roth IRAs in terms of letting you start over without a penalty if the market declines after you establish the GRAT. This may be your last chance to make a tax-free transfer of wealth to younger generations through the utilization of short-term GRATs. Congress is considering legislation that would eliminate this opportunity.  
 

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Charitable remainder trusts (CRTs”) are a popular technique for obtaining income tax benefits and providing money to charity. Due to a law passed in 2001 as part of the Act that repealed estate taxes for this year, there is a significant gift tax risk associated with CRTs established this year.

Many CRTs make payments to the grantor of the trust for lifetime or for a period of years. The unintended effect of the law is to treat the Grantor’s retained interest in a CRT as a taxable gift. The "phantom" taxable gift will cause unnecessary gift taxes to be paid and/or increase estate taxes payable upon the Grantor's death.

Several groups have written letters to the IRS requesting relief from the gift tax problem. Treasury officials have informally advised certain attorneys that guidance concerning this issue will be forthcoming in the near future. It is not certain what the guidance will say. Therefore, you should not create a CRT until the guidance is issued.

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If you are a beneficiary of a trust that requires income to be distributed to you, you may be able to increase your trust distributions by taking advantage of a new Tennessee law that will become effective on July 1, 2010. Section 21 of Public Chapter No. 725 of the Tennessee Public Acts of 2010 authorizes a trustee of a trust that requires mandatory distributions of net income to convert the trust to a total return unitrust.

The effect of a conversion is to change the trust distributions from “income” to a fixed percentage of the value of the trust. Assume that your trust has $1 million of assets and generates net income of $25,000 per year. If the trust is converted to a 4% unitrust, your distributions will increase to $40,000.

The fixed percentage must be between three percent (3%) and five percent (5%). Ideally, the income and remainder beneficiaries of the trust will agree to the percentage in advance. If the beneficiaries fail to agree in advance, the trustee will either not make the conversion or will choose the percentage on its own.

The conversion can be made without a court proceding if certain procedures are followed. If the Trustee is not “disinterested,” the Trustee must appoint a disinterested person to determine the unitrust percentage, the method to be used in determining the fair market value of the trust, and which assets are to be excluded in determining the unitrust amount. The trustee must send written notice of the proposed conversion to all qualified beneficiaries of the trust and not receive an objection within thirty (30) days. If a beneficiary objects, the Trustee can petition the Court to approve the conversion.

The main benefit of making a conversion is to eliminate an inherent conflict of interest between the income and remainder beneficiaries. With an all income trust, the income beneficiaries generally want the trustee to purchase investments that generate a lot of income and remainder beneficiaries want the Trustee to purchase assets that will appreciate in value. As a general rule, high income investments do not appreciate as much in value. When payments to the income beneficiary are dependent on the value of the trust rather than income received, the income beneficiary prefers for the trustee to maintain an investment policy that results in growth of the value of the trust over time. Growth will increase distributions to the income beneficiary and will also benefit the remainder beneficiaries of the trust.

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I came across an interesting article which concludes that federal estate and gift taxes account for the elimination of numerous small businesses, thereby promoting the concentration of wealth in larger firms. I can attest to the accuracy of this conclusion based upon several family businesses that I have worked with over the years.

All businesses have market risks, including competitors and obsolescence of their products. Family businesses have two significant additional risks, succession and estate and gift taxes.

The succession risks are two-fold. First, is there a manager or management team that can continue to operate the business in a profitable manner after current management retires or dies? For example, one of my clients is ready to retire, but has no one in his family or company who would be able to run the business if he retires or dies. He is entertaining offers from larger competitors and venture capital funds.

The second succession issue relates to financial and emotional family issues. Is there a way to treat everyone fairly and keep everyone happy after the patriarch or matriarch dies? As businesses move down generations, family issues often place a heavy burden on the business.

Estate and gift taxes present a major obstacle to successfully passing down the family business. I am currently working with the owners of a third generation family business that has been very successful for approximately 70 years. The management and family succession are aligned in a manner that will allow this business to pass smoothly to the fourth generation. However, finding a way to deal with estate and gift taxes is an enormous problem.

My clients are aggressively attacking the estate and gift tax issue on several fronts. First, they purchased $5 million of life insurance while they were insurable. Second, they have established various trusts to which they have been making gifts over several years. This effort has taken away part of their time that could have been spent in growing the business. More importantly, they have spent significant legal, accounting, appraisal and insurance costs. Despite taking all of these steps, they are still looking at an estate tax bill of $12 million. The estate taxes will drain the house and cash and will force the family to borrow money from the government to pay the remaining estate tax.  If the family finances a portion of its estate tax liabilities, profits from the business will be dedicated to paying this liability for several years, leaving the family with insufficient funds to pay for anticipated living expenses.  Because of these estate tax issues, the family is evaluating offers from some of its publicly traded competitors. 

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Tennessee has enacted a new law that will allow Courts to modify the terms of a Will to achieve the decedent’s probable tax objectives. Because the decedent will not be available, the Court will have to rely upon guidance from the decedent in the Will or another document and/or testimony from the decedent’s estate planning attorney and/or other advisors who were aware of the decedent’s tax objectives.

Courts will prefer to rely upon written guidance from the decedent. Therefore, I plan to add a new paragraph to Wills that I draft stating “I want my family to pay the least amount of federal and state, estate, inheritance, income and generation-skipping transfer taxes.” This provision will need to be modified for testators who do not mind paying higher taxes when it allows them to better accomplish their objectives.

When the decedent does not provide guidance of his or her tax intentions in the Will or another document, the Court will have to rely upon testimony from the decedent’s advisors and/or family members. I can envision cases where this works well. I also anticipate more difficult cases where determining the decedent’s intent will be more problematic for the Court.

The new law will become effective July 1, 2010. However, the Court is allowed to provide that the modification has retroactive effect.

The new law only applies to Wills and not revocable trusts. However, the Tennessee Uniform Trust Code already contains provisions that allow a Court to modify the terms of a trust to achieve the Settlor’s tax objectives. T.C.A. § 35-15-416.
 

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The Tennessee legislature has enacted the Tennessee Community Property Trust Act of 2010. If the Governor signs the bill, the new law will allow resident and nonresident married couples to convert their property to community property by transferring the property to a new type of trust known as a Tennessee Community Property Trust. Alaska is the only other state that allows residents of common law states to voluntarily convert some of their assets to community property.

There are three types of benefits that a Tennessee Community Property Trust will provide. First, community property is a property ownership system that provides for equal ownership of property by husband and wife, including a sharing in the appreciation and income from the property. Some couples may find this equality and sharing arrangement to be a preferred form of property ownership.

Second, community property receives a significant federal income tax advantage. At the death of the first spouse to die, both spouses’ interests in the community property will be eligible to receive a basis increase (not to exceed fair market value), up to a maximum increase of $4,300,000 in 2010, and a full basis adjustment to the fair market value of the property for deaths in 2011 and later years. As a result, there will be no capital gains tax payable if the first spouse dies in 2011 or later and the property is sold for its value after the first spouse’s death. Further, the increased basis will allow for increased depreciation deductions for business and investment depreciable property. If the property had been jointly-owned by the husband and wife in a common law state such as Tennessee, only one-half of the property would receive such an adjustment in basis.

Assume that in 1983 John and Martha Brown paid $200,000 for a farm that is worth $600,000 at the time of John’s death in 2011. Federal tax law allows Martha to increase the income tax basis of John’s half of the farm to $300,000 (one-half of the fair market value of the entire farm). Martha’s basis for her half of the farm will remain at $100,000 (one-half of the original purchase price). Thus, Martha’s total basis in the farm will be $400,000. When Martha sells the farm for $600,000, she will realize a capital gain of $200,000 and pay a federal capital gains tax of $40,000. Federal tax law would allow Martha to increase the basis of the farm to $600,000 if the farm had been held in a Community Property Trust. Thus, when Martha sells the property, she will not pay any capital gains tax.

The third advantage of a Tennessee Community Property Trust is the division of assets owned by the trust for purposes of  funding a credit shelter trust upon the death of the first spouse and obtaining fractional interest discounts upon the death of the surviving spouse. Funding the credit shelter trust and obtaining fractional interest discounts will reduce Federal estate tax and Tennessee inheritance tax upon the death of the surviving spouse. These same advantages can be obtained by converting ownership to tenancy-in-common; however, tenancy-in-common will not allow the favorable income tax advantage discussed above.

A Community Property Trust has the following requirements:
(1) It must declare that the trust is a Tennessee Community Property Trust and contain certain language that gives notice of the consequences of the trust;
(2) At least one trustee must be Tennessee resident or a Tennessee bank or trust company; and
(3) It must be signed by both spouses.

If the spouses divorce, the trust will terminate and the trustee must distribute one-half of the trust assets to each spouse. When property is distributed from a community property trust, it will no longer constitute community property. The equal division of the trust assets upon divorce may be different than the division that would have occurred if assets had not been transferred to the trust.

A debt incurred by only one spouse before or during marriage may be satisfied from that spouse’s one-half share of a community property trust and a debt incurred by both spouses during marriage may be satisfied from all of the trust assets. Thus, a Tennessee Community Property Trust has inferior creditor protection to tenancy by the entirety ownership, and should not be utilized by couples with potential creditor problems.

The new law will become effective July 1, 2010. I expect that Tennesseans will establish a lot of these trusts in July of 2010, similar to the wave of Tennessee Investment Services Trusts that were established in July of 2007 when the Tennessee Investment Services Trust Act became effective. It will take longer for Tennessee banks and trust companies to market the advantages of this opportunity to nonresidents. The advantages will be greater for nonresidents who live in states that impose income taxes on capital gains and rental income.
 

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People who die in 2010 do not have to pay federal estate taxes (unless Congress enacts a retroactive change in the law). However, most people have assumed that there would be federal estate taxes at the time of their death. Based on this assumption, numerous Wills have formulas that are based on the federal estate tax system. In many cases, these formulas are either difficult or impossible to interpret in the current environment. These broken formulas will lead to distorted estate plans and needless litigation.

The Tennessee legislature has taken a bold move to revise wills of people dying in 2010 which contain references to the federal estate tax system. On Monday, March 1, 2010, the House approved SB 3045, which had previously been approved by the Senate. Assuming the bill is signed by the Governor, all references to the federal estate and generation-skipping transfer tax laws will be interpreted as they applied with respect to estates of decedents dying on December 31, 2009.

In order for the new law to apply, the Will must:

1. contain a formula referring to the "unified credit," "estate tax exemption," "applicable exemption  amount," "applicable credit amount," " applicable exclusion amount," "generation-skipping transfer tax exemption," "GST exemption," "marital deduction," " maximum marital deduction," or " unlimited marital deduction."
2. measure a share of an estate or trust, based on the amount that can pass free of federal estate taxes or the amount that can pass free of federal generation-skipping transfer taxes; or.
3. is otherwise based on a similar provision of federal estate tax or generation-skipping transfer tax law.

The new law will apply to decedents who die after December 31, 2009, but before January 1, 2011. The new law will also apply to formulas contained in revocable trusts.

The new law will not apply if:

1. federal estate taxes are reinstated retroactive to January 1, 2010;
2. the Will or trust is executed or amended after December 31, 2009;
3. the Will or trust manifests an intent that a contrary rule will apply if the decedent dies on a date on which there is no then-applicable federal estate or generation-skipping transfer tax;
4. the Executor, or Trustee of a revocable trust, and all beneficiaries who would be affected by the new law, opt for the new law not to apply within nine months of the decedent's death; or
5. the Executor, or any affected beneficiary, files a court proceeding within 12 months following the decedent's death, and convinces the court that the decedent intended for the formula to be construed based upon the law as it existed after December 31, 2009.

The great majority of wills that I have drafted over the last several years will actually work better without the new law. In order to get the full benefit allowed by the absence of federal estate taxes, the family will be forced to opt out of the new Tennessee law. There is always a danger that one or more family members will withhold their consent as a bargaining chip or because they are disappointed with the Will.

I knew several of my clients had a problem. I have been busy preparing codicils and amendments to revocable trusts to correct these problems. Though I hope to identify and fix all of the problem documents, it is certainly possible that one of my clients could die before fixing the problem and I will be glad that the new law was passed.

The new law will help numerous individuals who were unable to make changes or chose not to amend their documents. However, in some cases, the new law will be harmful and will force families to sign a unanimous agreement or file a court proceeding. In all cases, it is better to make sure that your documents clearly state your wishes without having to rely on the new law, or a lawsuit, or a document to be signed by your family after you die.
 

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The simplest estate plan for a married couple is for them to own everything jointly, with the result that everything will be owned by the survivor after the death of the first spouse to die. Unfortunately, the Federal estate tax and Tennessee inheritance tax laws penalize couples for taking the simple approach if their combined assets exceed $1 million in value. This is because the survivor’s estate will exceed the available exemptions from federal and Tennessee inheritance tax.

A better tax plan is for the couple to each own separate assets or to own assets as tenants-in-common. If the first spouse to die owns a tenancy-in-common interest in real estate or a brokerage account, the decedent’s Will can transfer these assets to a credit shelter trust for the primary benefit of the survivor. The credit shelter trust will not be subject to tax upon the subsequent death of the survivor.

The first spouse to die must own assets that can be transferred to the credit shelter trust. For Tennessee residents, this is not possible with assets that are owned jointly with a spouse, unless the form of ownership is specifically designated as tenancy-in-common. As in most states, there is a presumption in Tennessee that property held jointly by a husband and wife is held as tenants-by-entirety, rather than as tenants-in-common. This means that the assets will not be available to fund a credit shelter trust upon the death of the survivor.

In the Estate of Oscar Goldberg, the failure to change ownership of real estate to tenancy-in-common resulted in litigation with the IRS and unnecessary estate taxes of almost $400,000. When it comes to estate planning, simplicity may carry a high price tag for your children.
 

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2010 is the year where there will be no federal estate taxes due to a law that was passed in 2001. The heirs of wealthy individuals who die this year are set to enjoy a huge windfall.

Several congressmen have vowed to reinstate estate taxes during the year. Indeed, the Senate Finance Committee Chairman, Max Baucus, has vowed that Congress will reinstate federal estate taxes retroactive to January 1, 2010.

The one year repeal of federal estate taxes and the threat of a retroactive repeal of the repeal requires planning for three separate tax systems that have very significant differences. System #1 is the law that currently exists for 2010. Even though you do not have to “worry” about federal estate taxes, planning for someone’s death in 2010 is challenging for several reasons.

First, Tennessee still has an inheritance tax with an exemption of only $1 million. Second, there are numerous Wills containing formulas that will not work if the testator dies in 2010. Third, most outright bequests should be converted to trust bequests in order to avoid estate or generation-skipping tax upon the subsequent death of the beneficiary.

Finally, System #1 eliminates the automatic step-up in basis for inherited assets. Heirs will need to obtain records that establish the decedent’s historical cost basis in his or her assets. Furthermore, if there was substantial appreciation, the heirs will incur capital gains tax when they later sell the assets. Each decedent has $1.3 million worth of basis increase that can be allocated by the executor. There is an additional $3 million worth of basis increase that can be allocated to assets passing to a surviving spouse. These “basis exemptions” will solve problems for most families, but will have numerous complications in their application.

System #2 is the law that will apply beginning in 2011, when the federal estate tax will reappear with a $1 million exemption and a top marginal rate of 60%. Planning for System #2 is very familiar because this system was in place prior to the changes made in 2001. A lot of families have assumed that the federal estate tax exemption was always going to be significantly higher than $1 million. They have failed to take planning steps that seemed to be unnecessary.

System #3 is what Congress might put into place later this year. My best guess is that System #3, if enacted, would be similar to the system that was in place for 2009. The House passed such a bill in December of 2009. The Senate elected not to pass this bill, but could change its mind. If there is a System #3, it is possible that it could make changes that were not part of the bill passed by the House in December of 2009. For example, discounts for Family Limited Partnerships could be eliminated.

Many people will assume that System #1 will not be relevant for them, because they will not die this year and/or the law will be changed before they die. If the law is not changed retroactively, it is inevitable that the families of some wealthy individuals who die this year will be disappointed despite the absence of federal estate tax.

There is widespread sentiment that System #2 will not arrive. I now believe that System #2 might arrive in 2011 because I have no confidence that the Senate will be able to get the 60 votes necessary to enact System #3.

You need to be prepared for all 3 systems. Fortunately, there are practical steps that can be taken to minimize taxes under all 3 systems.

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It now appears very likely that we will begin the new year with no Federal estate tax in place. A law passed in 2001 repealed Federal estate taxes for the year 2010. That same law provided that the estate tax would reappear in the year 2011 with a $1 million exemption amount and a top rate of 55%.

Congress has known about this anomaly for the last 8 years. There has been universal agreement that the law needed to be amended in some fashion. Nevertheless, the law has not been changed because Congress could never agree on how to change it.

One group of legislators wants to permanently repeal estate taxes. Another group wants to retain estate taxes with a higher exemption amount than $1 million. It is widely predicted that Congress will address this issue early in 2010 and perhaps reinstate estate taxes effective as of January 1, 2010. An attempt to enact a retroactive tax might be a violation of the United States Constitution. There is some precedent suggesting that a retroactive tax would be allowed if enacted.

There is another significant issue for persons dying in 2010. Assets will no longer receive a basis equal to the date of death value of the assets, which is current law. Instead there will be a "carryover basis" regime, with the ability to obtain a "step-up" in basis for a limited amount of assets. A similar regime was briefly enacted in the 1970s, and was repealed almost immediately because it was so impractical. It is very difficult to establish the historical basis of inherited assets. Additionally, heirs of many estates that would not have been required to pay Federal estate tax under current law will now have to pay capital gains taxes when they sell inherited assets.

Planning your estate amidst this uncertainty is challenging. You need to be prepared for the law that is on the books, i.e., a federal exemption of only $1 million per person in future years. You also need to make sure that your Will will work in the manner intended if you die during the year 2010. In particular, you need to review any formulas in your Will that are based on an estate tax system that may not exist at the time of your death.

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The father of one of my clients is considering a move to Nashville in order to be closer to his daughter and grandchildren. He called me regarding the state tax consequences of moving to Tennessee.

The good news is that his income taxes will decrease slightly because Tennessee will not tax his IRA distributions. He will pay the Hall income tax on his dividends and interest, but he is already paying taxes on that income in the state where he currently lives.

The bad news is that Tennessee inheritance tax will apply to his estate when he dies. He currently lives in one of the many states that does not have a state inheritance tax. Based on his estate of $3.5 million, his Tennessee inheritance tax bill will be approximately $225,000.

Inheritance taxes would be much higher if his estate has to pay inheritance tax on the $6 million marital trust that his wife established upon her death. The marital trust will be taxable for federal estate tax purposes. However, Tennessee does not tax marital trusts that were established by residents of other states. Since the Tennessee inheritance tax rate is 9.5%, not having to pay Tennessee tax on the marital trust will reduce his estate’s Tennessee inheritance tax bill by $570,000. He told me that this tax reduction is good enough to allow him to move to Tennessee.  If the marital trust would be subject to Tennessee inheritance tax, he probably would not move.

The planning opportunity is to have a marital trust established for your benefit prior to moving to Tennessee. If you know friends or family members such as parents who are considering a move to Tennessee, encourage them to establish and fund a marital trust prior to moving to Tennessee. For example, a husband might establish a marital trust for his wife prior to moving. The marital trust will not escape federal taxes; however, it will escape Tennessee inheritance taxes because it was established by a non-resident of Tennessee.
 

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Yesterday, I met with a spry 90 year old widow who believed that her Will gave $1 million to her grandchildren. I determined that her will actually gives $3.5 million to her grandchildren. If she had died with this Will, her grandchildren would have received significantly more than her two sons.

The reason for my client’s misunderstanding was her Will’s use of a formula. The bequest to the grandchildren was an amount equal to her “available GST exemption”. When her Will was drafted, her "available GST exemption" was $1 million. However, due to law changes that have occurred over the last several years, her GST exemption increased to $3.5 million.

It is very common for Wills to contain formulas that are based upon tax laws. This allows your Will to take advantage of changing exemption amounts without having to redraft your Will every time there is a law change. However, when a Will uses a formula, your attorney should explain the effect of the formula. I suspect that my client’s former attorney did explain the formula. Nevertheless, all she remembered was that the formula resulted in a bequest of $1 million.

There are a lot of formulas that are going to be distorted if Congress does not amend the estate tax laws within the next three weeks. As the law is currently written, there will be no federal estate taxes in the calendar year 2010. Because a lot of formulas are written based upon laws that simply will not exist for people dying in 2010, numerous formulas will not make any sense. Other formulas will be open for debate. As an example, I believe that my client’s Will will result in a bequest of $0 to her grandchildren, because it refers to an exemption amount that will simply not exist in 2010. The grandchildren might challenge that result as not representing their grandmother’s intent. I predict that there will be multiple lawsuits regarding these types of results if Congress does not change the law for 2010.

Tax-driven formula provisions in Wills are widely used and serve a useful purpose. Make sure you know what your formula means, and recalculate the results of your formula from time to time. If Congress does not change the tax laws in the next three weeks, everybody needs to check their formulas.
 

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The Congressional Research Service (“CRS”) has issued a report titled “Estate and Gift Taxes: Economic Issues.” The CRS is a “think tank” that provides reports to members of Congress on a variety of topics. Taxpayers spend over $80 million per year to fund the CRS. One controversial conclusion of the report is that

“…Only a tiny fraction of farms and small businesses face the estate and gift tax and it has been estimated that the majority of those who do have sufficient non-business assets to pay the tax. Moreover, only a small portion of the estate tax is collected from these family owned farms and small businesses, so that dramatically reducing estate tax rates or eliminating the tax for the purpose of helping these family businesses is not very target efficient.”

This report is supposedly based upon data from estate tax returns that have been filed. However, the conclusions drawn in the report are not realistic.

A lot of my clients have farms and small businesses. These clients worry a great deal about estate taxes. They purchase large life insurance policies to provide funds to be used to pay taxes. They establish and fund irrevocable trusts and various entities including limited liability companies and/or limited partnerships. They make gifts and sales to trusts for their children sooner than they would prefer if there were no estate taxes.

As mentioned in the report, some families are able to accumulate enough liquidity outside the business to pay taxes. In some cases, this means that the only asset left to pass on to children is the family business. When one or more children do not work in the business and cannot draw a salary from the business, this is not a happy result.

Perhaps my view is distorted because of the region in which I practice. Middle Tennessee probably has more valuable farmland than other areas of the country. The value is not necessarily based on the value of the land for farming. In many cases, the value of the farmland is artificially inflated by the development potential of the property.

Middle Tennessee also has a keen entrepreneurial spirit. I am constantly amazed by the ingenuity of my clients and how they have amassed a fortune from one or more business opportunities.

Nevertheless, the notion that reducing taxes on family businesses is not worthwhile clearly misses the mark. Owners of farms and successful family businesses spend a lot of time and money on planning strategies to cope with the liquidity crunch and distortions to their estate plan that are caused by estate taxes.

Members of the House of Representatives were not fooled by the Report. They understand that estate taxes create severe problems for owners of farms and family businesses. On December 3, 2009, they passed the Permanent Estate Tax Relief for Families, Farmers, and Small Businesses Act of 2009. Though this bill does not eliminate estate taxes, it seeks to ensure that married couples will be able to leave up to $7 million to their children without paying federal estate taxes. This bill has been forwarded to the Senate, where it faces an uncertain fate.
 

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The estates of a lot of Tennessee decedents pay Tennessee inheritance taxes but do not pay federal estate taxes. The federal estate tax exemption is currently $3.5 million. As of the date of this article, various members of Congress favor extending this exemption amount indefinitely into the future. The Tennessee inheritance tax exemption is currently $1 million. There does not appear to be much likelihood that Tennessee will increase its exemption to match the federal exemption.

The difference between the federal and Tennessee exemptions means that unmarried decedents who die with a taxable estate with a value between $1 million and $3.5 million will pay Tennessee inheritance taxes but not federal estate taxes. There are several things that can be done to reduce the value of assets for Tennessee inheritance tax purposes.

Some of these steps can be taken shortly before death. As an example, a parent might make a deathbed gift of a fractional interest in real property to a child with the goal of capturing a fractional interest discount for the remaining portion of the property when the parent dies. There are also various post-mortem decisions that can affect the value of the assets owned by the estate.

Even though the estate is not subject to federal estate taxes, the date of death value of the assets becomes the basis of the assets for federal income tax purposes. Basis will be relevant when the estate or the beneficiaries later sell the assets. Federal capital gains taxes are 15% and are scheduled to increase to 20% in the year 2011. If the beneficiaries live in a state outside of Tennessee that imposes a capital gains tax, this will make the capital gains tax rate even higher. The maximum Tennessee inheritance tax rate is 9.5%.

Since capital gains tax rates are higher than the maximum Tennessee inheritance tax rate, it is generally not advisable to take steps that reduce the value of the decedent’s assets for Tennessee inheritance tax purposes, unless it is known that the beneficiaries will continue to own the assets in the estate for several years. The reduction in the value of the estate will increase capital gains taxes by more than the Tennessee inheritance taxes that are saved.

Making tax-free annual exclusion gifts is still a good idea. It is better to give cash as opposed to an appreciated asset that will receive a free basis increase upon death. A cash gift reduces Tennessee inheritance taxes without increasing capital gains taxes.
 

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I am currently working with a client who plans to make $2 million of bequests to his favorite charities upon his death. His estate will receive an estate tax deduction for these bequests; however his estate will not receive an income tax deduction for these bequests.

I told him about a different method for making the payments that will require the cooperation of his wife. The plan works as follows:

1. His Will makes a $2 million cash bequest to his wife.
2. The Will makes a non-binding request for his wife to consider making gifts to his favorite charities.
3. After my client dies, his wife will receive $2 million and will make charitable gifts of $2 million.

The revised plan will have the following tax consequences: My client’s estate will receive a $2 million marital deduction for estate tax purposes. This replaces the $2 million charitable estate tax deduction that he would have otherwise received. His wife will get a $2 million income tax deduction. Since his wife will be in the highest income tax bracket (currently 35%), she will save $700,000 on her income taxes. Her income will not be large enough to receive the entire deduction in the first year. Rather, it will take about four years. Nevertheless, she will receive substantial income tax savings that would not have been realized if her husband had given the money directly to charity.

The risk for my client is that his wife will not make the charitable gifts. Legally, she can keep the money. My client trusts his wife to honor his wishes, especially since his wife likes most of his favorite charities.
 

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I discourage the use of a marital trust for a surviving spouse when the decedent’s children from a prior marriage will be the remainder beneficiaries. Such trusts have an inherent conflict of interest and should be avoided when possible.

Most marital trusts base the payments to the surviving spouse on the trust’s income. The surviving spouse wants the Trustee to purchase investments that produce a lot of income. Conversely, the stepchildren prefer the Trustee to invest in assets that will appreciate in value over time.

When a marital trust is the only practical solution, I recommend a marital unitrust, which works as follows: The surviving spouse receives the greater of the income earned by the trust or five percent (5%) of the value of the trust determined as of the beginning of each calendar year. In order to reduce volatility in the amount of the annual payments to the spouse, payments should be based on a 3 year average of the value of the trust.

The Trustee invests in a mixed portfolio of equities and fixed income investments. Principal assets will need to be liquidated each year to make the payments to the spouse because income will be significantly less than 5%.

The spouse wants growth because it will increase distributions in the future without reducing current distributions. The Trustee’s job will be much easier to accomplish because the spouse and the stepchildren will have the same goals.  
 

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Family limited partnerships (or LLCs) are often used to obtain valuation discounts for estate and gift tax purposes. Appraisers typically conclude that the fair market value of an interest in a family limited partnership (“FLP”) is at least 35% less than the value of the assets owned by the FLP.

The IRS dislikes these discounts and has successfully challenged the discounts in several court decisions. As a general rule, the taxpayers were "sloppy" in the cases that the IRS has won. Errors were made either in funding, distributions, or record keeping.

When the FLP is properly funded and administered, taxpayers are able to substantiate the discounts. For every case in which the IRS has successfully disallowed discounts, there are many others where the court approved a discount or the IRS agreed to a discount without going to trial.

A case in point is the recent Rayford L. Keller et al v. United States decision. Mrs. Williams was in the hospital, dying from cancer. Six days before her death, she signed documents to establish an FLP to be funded with $240 million of bonds and $10 million cash.

The assets were not transferred to the FLP until one year after she died. Nevertheless, the Court ruled that her family was entitled to a 47.5% discount on the value of the bonds and cash that were transferred to the FLP.

I do not recommend waiting until death is imminent to establish an FLP. It is far better to establish the FLP when you have several years to live, and then to make gifts or sales of FLP interests when that is appropriate.

Detailed summary of Keller case by Steve Akers of Bessemer Trust Company, N.A.

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More than 50% of marriages end in divorce. When one spouse enters the marriage with significant assets, they often leave with less than they started with.

The traditional method for protecting your assets is to enter into a prenuptial agreement before you get married. I recommend this to all of my clients who are getting married.

In lieu of or in addition to a prenuptial agreement, Tennessee residents can protect their assets by transferring them to an asset protection trust {pdf} before they get married. Even if they do not have a prenuptial agreement, their spouse will not be entitled to any of the trust assets upon divorce. Furthermore, their spouse will not be able to claim any portion of the trust assets upon death. This latter point is especially important for later-in-life marriages when one or both spouses have children from prior marriages.

I have mostly used pre-marital asset protection trusts for young adults who have received substantial gifts and/or inheritances from their parents and grandparents. As a general rule, these young adults have relied solely upon the protection afforded by the trust because they were not willing to discuss a prenuptial agreement with their future spouse.

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