Two-Trust Gifting Plan Finesses Tennessee Inheritance Tax and Wandry Formula Concerns

 I am currently working with an elderly gentleman who wants to make a gift of $5.25 million of LLC units to a trust for his wife and children.  The value of the LLC units is uncertain.  We are obtaining an appraisal of the LLC units; however, the IRS may disagree with the appraisal.

In addition to the valuation issue, my client may die within the next two years, which will cause the value of the gift to be added to his estate for Tennessee inheritance tax purposes.  Unless the gift qualifies for the Tennessee inheritance tax marital deduction, his estate will owe Tennessee inheritance taxes which could be as much as $400,000.  This tax will apply even if he gives his entire estate to his wife.

In order to address the valuation issue and the Tennessee inheritance tax issue, my client will establish a typical family trust, and a Tennessee QTIP Trust.  The family trust will receive LLC units equal in value to $1.25 million as finally determined for federal gift tax purposes.  The technique of making a gift that depends on the value determined for federal gift tax purposes is known as a “Wandry” formula, based upon a recent Tax Court case involving an analogous gift by Mr. Wandry.

The Tennessee QTIP trust will receive my client’s remaining LLC units that he intends to give which have an appraised value of $4 million.  When my client files his 2013 federal gift tax return, he will make a QTIP election for the gift to the Tennessee QTIP trust of whatever amount is necessary to reduce federal gift taxes to $0.  This formula marital deduction will ensure that no federal gift tax is payable even if the appraised value of the LLC units is successfully challenged by the IRS.

If my client dies before 2016, the gifts to both trusts will be added to his estate for Tennessee inheritance tax purposes.  His estate will make a Tennessee QTIP election for the Tennessee QTIP trust pursuant to T.C.A. § 67‑8‑315(a)(6).  By making the Tennessee QTIP election, inheritance tax will be avoided upon his death.  If his wife also dies before 2016, the assets of the Tennessee QTIP trust must be included on her Tennessee inheritance tax return.  However, if she lives to 2016 or beyond, Tennessee inheritance tax will be totally avoided.

Tennessee Inheritance Tax Repealed

The Tennessee legislature repealed Tennessee’s inheritance tax, effective as of January 1, 2016. This means that if you can survive until 2016, you will not owe any Tennessee inheritance taxes. If you die before that date, you will owe taxes if your taxable estate exceeds the following exemption levels:

 

2012

$1,000,000

2013

$1,250,000

2014

$2,000,000

2015

$5,000,000


Since the tax still applies until 2016, Wills of married persons should still establish Tennessee QTIP Trusts. This will avoid tax at the first death. As long as the surviving spouse survives at least until 2016, the Tennessee inheritance tax will be permanently eliminated.

There are a lot of existing Tennessee QTIP Trusts (sometimes referred to as Tennessee Gap Trusts) for married individuals who died over the last few years or chose to make a gift to such a trust. These trusts are irrevocable and cannot be modified to add the children as beneficiaries or to change the income payout requirements for the spouse. Depending on the terms of the trust, it may be possible to distribute corpus of the trust to the spouse. Unfortunately, due to the instability of the federal estate tax laws, it would be imprudent to distribute assets from a TN QTIP trust to the spouse. As of January 1, 2013, the federal estate tax exemption is scheduled to be only $1 million. Distributing assets from the Tennessee QTIP Trust might increase federal estate taxes payable by the spouse’s estate.

The elimination of the Tennessee inheritance tax will eventually simplify estate planning for our clients. However, for the next four years, we must pay attention to this tax.

Tax Relief Act of 2010 - Part 3 - Temporary $5 Million Estate Tax Exemption

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.