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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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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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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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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Federal and state lawmakers continue to pass laws that provide tax and non-tax benefits to trusts. I have often wondered why legislators love trusts so much.

Richard Johnson and I did a presentation to the Nashville Estate Planning Council titled “60 Trusts in 60 minutes.” We came up with 65 different types of trusts. Let me know if we forgot any.
 

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My clients often want to make changes to an irrevocable life insurance trust (“ILIT”). Fortunately, there are at least 6 methods for making changes to an ILIT.

I recently worked with a business owner who used 4 different techniques to restructure a series of ILITs that he established over a 25 year period. Two of the ILITs owned insurance on his life. Two other ILITs owned last-to-die policies insuring the business owner and his wife.

The first step was to create two new ILITs. The wife is a beneficiary of the new Family Trust which now owns the single life policies. The other new ILIT was designed as a Dynasty Trust and now owns the last-to-die policies, as well as one single life policy.

Next, the wife exercised a power to appoint the assets of one ILIT to the Dynasty Trust. The trustee of another ILIT used the leapfrog power of TCA Section 35-15-816(27) to distribute its policy to the Family Trust.

The trustee of a third ILIT merged that trust into the Dynasty Trust pursuant to TCA Section 35-15-417. Finally, the trustee of the fourth ILIT sold its policy to the Dynasty Trust, which was structured as a grantor trust in order to avoid potential income tax issues associated with this sale.

I would have preferred to use the same technique for moving all 4 of the old ILITs into the Family Trust and the Dynasty Trust. However, different techniques were required due to the specific wording of the trusts, and other factors including tax consequences. Even though it was complicated, the business owner accomplished his goals and several generations of his family will benefit from these changes.

Incidentally, the two techniques that we did not use were: (i) amending the trust pursuant to TCA Section 35-15-411; and (ii) buying a new policy, which was not a viable alternative due to the age of the policies involved and health changes that have occurred.

See the enclosed article (PDF) for more detail on these techniques.

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