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

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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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 previously wrote about Edith Windsor, who was required to pay $350,000 of estate taxes because her deceased spouse was a woman rather than a man. This tax was caused by the Defense of Marriage Act (“DOMA”), which classifies same sex married couples as unmarried for purposes of federal taxation and various benefits.

President Obama has decided that certain portions of DOMA are unconstitutional and has directed the Justice Department to stop defending the law in court, including the pending appeal in the Windsor case.

There are many people who agree with the President’s assessment of the constitutionality of DOMA. Nevertheless, it is not the President’s job to determine the constitutionality of laws that have been enacted. Laws may be changed by Congress or ruled to be unconstitutional by the judicial branch of the government. It would create chaos if the President is allowed to prohibit enforcement of laws that he does not like.

If DOMA is overturned by Congress or the U.S. Supreme Court, this will be a watershed event for same sex married couples. There are numerous tax and non-tax benefits provided to couples who are treated as married by the federal government.

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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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The attached article recognizes Tennessee as one of four Tier 2 trust states. The four Tier 1 states have only two favorable features that Tennessee does not match.

First, Tennessee imposes an income tax on dividends and interest received by a trust with Tennessee beneficiaries. This is no different than if the beneficiaries owned the assets directly. Therefore, this is not really a trust problem. Nevertheless, there are seven states in the United States that do not impose income taxes on their residents.  Tennessee does not impose income taxes on trusts held for beneficiaries who are not Tennessee residents.

The other slight advantage for some states is the rule against perpetuities. Tennessee trusts must terminate after 360 years due to our state consitution. A few states allow trusts to last into perpetuity. The benefit of perpetual trusts is overrated. I have never had a client complain to me that 360 years is too short.  More than one-half of the other states require trusts to end after approximately 90 years.  The difference between 90 years and 360 years is material to a lot of my clients. 

Our legislature has made a concerted effort to keep our trust laws at the forefront. In addition to our comprehensive Tennessee Uniform Trust Code, our laws permit asset protection trusts, decanting, community property trusts, unitrust conversions, directed trusts, equitable adjustments, and a long perpetuities period.

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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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In his State of the Union address on January 25th, 2011, the President made the following statement: “Those with accountants or lawyers to work the system can end up paying no taxes at all. But all the rest are hit with one of the highest corporate tax rates in the world. It makes no sense, and it has to change."

I agree with the President that we have an unfair tax system. It is exceedingly complex and has numerous laws that are nonsensical. For example, a law was passed in 2001 that encouraged wealthy people to die in 2010. Numerous attempts to remove this perverse incentive were rejected by Congress. On December 17, 2010, the 2001 law was reaffirmed in a deal brokered by the President. The new law also created a new incentive for wealthy people to die in 2011 and 2012. I have decided that I will not encourage my clients to take advantage of this tax savings “opportunity.” I hope the President will approve of my decision.

I must take exception with the President’s criticism of my profession. I have an ethical duty to do the best job that I can of counseling my clients on how to arrange their affairs to lawfully minimize their tax obligations based upon the laws that Congress and the President have enacted. Indeed, I should be disbarred if I concealed from my clients the laws that Congress has passed that would allow them to reduce their tax obligations.

President Obama is an attorney himself. He knows our ethical obligations. I have some advice for the President: Don’t blame others for following the laws that he is at least partially responsible for passing. Enact fair and simple tax laws and you will have a system that is fair and simple.
 

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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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On December 17, 2010, the President signed the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (“Act”). In addition to extending the so-called “Bush” income tax cuts for two years, the Act made several significant changes to estate, gift and generation-skipping transfer taxes. This article is the first of a series summarizing various provisions of the Act.

The Act extended for 2010 and 2011 the ability of taxpayers who are at least 70½ years of age to transfer $100,000 per year from their IRA to charity. If you missed this opportunity in 2010 and may want to give more than $100,000 during 2011, you can do so if you act by January 31, 2011. There is a special provision that allows you to use the amount you didn’t use in 2010 during January 31 of 2011. Assume, for example, that you made a Charitable IRA Rollover of $20,000 on December 28, 2010. You can give as much as $180,000 in 2011. However, at least $80,000 of the 2011 Rollover must occur on or before January 31, 2011. You would then be able to give the other $100,000 any time during the year.

If the most that you would give in 2011 is $100,000, then you do not need to worry about the January 31 deadline. If you might give more than $100,000 this year, then you should roll over part of the gift before the end of January. For example, if you might give $150,000 this year, you should give at least $50,000 by January 31.

Before making a Charitable IRA Rollover, you should investigate making a Synthetic Charitable IRA Gift. The Synthetic Gift technique also helps those who do not qualify for a Charitable IRA Rollover or do not like some of the restrictions imposed with respect to Charitable IRA Rollovers.

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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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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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The American Family Business Institute has published a death tax voter guide for the 2010 elections. The voter guide identifies which candidates have signed a pledge to repeal death taxes as well as how incumbents have voted on various bills to permanently repeal death taxes.

I doubt that death taxes will be totally repealed. Nevertheless, those who have signed the pledge will presumably be more inclined to vote for estate tax relief in the form of higher exemptions and lower tax rates.

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 John Kluge recently became the fifth United States billionaire to die in 2010. The others are Mary Janet Cargill, Dan Duncan, Walter Shorenstein, and George Steinbrenner.

The families of these five billionaires will receive a tremendous tax break due to the absence of federal estate taxes in 2010. It is still possible that Congress will pass a retroactive estate tax to keep these families from enjoying this windfall. If Congress does attempt to impose a retroactive tax, these families, among others, can be expected to challenge the constitutionality of the tax.

Meanwhile, numerous widows and widowers with estates of $2 million to $3 million are worried about dying in 2011. Their families will pay substantial estate taxes unless Congress “fixes” 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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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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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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The past decade has seen a vast improvement in Tennessee's trust laws, making it one of the leading states for establishing a trust. Major laws that have been enacted include the Uniform Principal and Income Act (2000), the Tennessee Uniform Prudent Investor Act of 2002, the Tennessee Uniform Trust Code (2004), the Tennessee Investment Services Act of 2007, and the Tennessee Community Property Trust Act of 2010.

On April 9, 2010, the Governor signed another law that makes numerous improvements to the trust laws. The new law includes provisions providing enhanced creditor protection for various trusts, including special needs trusts and inter vivos marital trusts, and contains a provision allowing a Trustee to convert a mandatory income trust to a “unitrust” with an annual payment of between three percent (3%) and five percent (5%). I will be writing additional articles to provide more details about these changes.
 

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A prior article pointed out that higher tax rates in the future would increase the chance that converting your IRA to a Roth IRA would provide a benefit to you and your family. We now know that income tax rates for high-income individuals will increase beginning in 2013, due to the 2010 Healthcare Act.

High-income taxpayers, defined as single people earning more than $200,000 and married couples earning more than $250,000, will be hit with a a tax increase on wages and a new levy on investments. Under the provisions of the new law, which take effect in 2013, high-income taxpayers will be taxed at an additional 0.9% on wages exceeding $200,000 for single people or $250,000 for married couples.

Beginning in 2013, a new 3.8% tax will be imposed on net investment income of high-income taxpayers. Net investment income includes interest, dividends, royalties, rents, gross income from a trade or business involving passive activities, and net gain from disposition of property (other than property held in a trade or business). Net investment income is reduced by properly allocable deductions to such income. However, the new tax will not apply to income in tax-deferred retirement accounts such as IRAs and 401(k) plans. Also, the new tax will apply only to income in excess of the $200,000/$250,000 thresholds.

These new taxes enhance the benefits of a Roth IRA conversion in two respects. First, if you do not make the conversion, the required distribution from your regular IRA will increase the chance that you are a high-income individual. Even though the new investment tax will not apply to the amount distributed from a regular IRA, the income from the IRA may force more of your other income to bear a 3.8% tax. If you had converted to a Roth IRA, you would not be required to take a required minimum distribution. Even if you take a distribution, it would not be considered income.

If you make a Roth IRA conversion, it is advisable to pay the income taxes from separate assets. If you do not make a conversion, the income from those separate assets would be hit with this 3.8% investment tax. Stately differently, the after-tax income that you would have received from the money used to pay the conversion tax will be decreased due to the new 3.8% investment tax.

The increased taxes for high-income taxpayers may only be getting started. The new taxes in the Healthcare Act help to pay for the benefits provided by the Act. Many have predicted that the cost of the new Act will substantially exceed the government’s estimates. If this is true, someone will have to pay for the additional costs.

Regardless of whether the new taxes fully pay for the Healthcare Act, someone needs to pay for the burgeoning federal deficit. High-income taxpayers will be a likely target. Any additional taxes imposed in the future will further enhance the benefit of having made a Roth IRA conversion in 2010.
 

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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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