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.

The American Taxpayer Relief Act of 2012 established a $5,000,000 estate and gift tax exemption to be adjusted on a yearly basis due to changes in inflation.  The IRS has announced that the indexed exemption for 2014 will increase from $5,250,000 to $5,340,000.  This means that, with proper planning, a married couple can transfer $10,680,000 to their children without paying estate or gift taxes. 

A lot of our clients used their full exemption in 2012 ($5,120,000) and are taking a breather in 2013.  However, some of them have also given away the extra $130,000 that can be given in 2013 without paying gift taxes. 

The increased exemption also applies for generation-skipping transfer tax purposes.  A few of our clients who made the maximum gift in 2012 did not have sufficient generation-skipping transfer tax exemption to totally protect the trust.  They can now file a gift tax return to use the extra exemption to protect the trust from future generation-skipping transfer taxes. 

The annual gift tax exclusion will remain at $14,000 per donee in 2014.  

There have been very few cases involving decanting, a technique that allows the trustees of an irrevocable trust to distribute the assets of the trust to a second irrevocable trust with different terms.

In the attached case, Matter of Schreiber, the New York Attorney General tried to overturn a decision made by the Trustees of a Minor’s Trust to decant the assets of the Trust to a Special Needs Trust prior to the beneficiary’s 21st birthday.  The Special Needs Trust allowed the beneficiary to qualify for Medicaid benefits in New York.  If the Trustee had not decanted the Trust assets from the Minor’s Trust, the beneficiary would have been able to withdraw the Trust assets upon his 21st birthday and would have been ineligible for Medicaid.  The Court analyzed the decanting statute in New York (which is very similar to the statute in Tennessee) and concluded that the Trustee’s exercise of the decanting power was valid under New York law.

If you are a Trustee of a trust for a minor or young adult that will be terminating in the near future, you should consider decanting the trust to a different trust to maintain eligibility for government benefits or to otherwise protect the assets from the numerous bad things that can happen to money placed in the hands of a young adult.

This week, I worked with three different clients whose families had some involvement with one or more disinherited children. Two of my clients treat their children disproportionately, or totally disinherit a child. The third client has been emotionally and financially disinherited by one of her parents. I ruminated on the family circumstances that led to the disparate treatment of the children. In all three families, the disinherited child’s natural parents went through a bitter divorce. In all three families, the parent who is disinheriting a child had remarried. One parent who is disinheriting a child was disappointed in the child, primarily because the child "favored" the child’s other parent.

When I reflected on other clients of mine who are either disinheriting a child or have been disinherited, or whose sibling has been disinherited, I noticed a pattern. In a significant percentage of these families, there was a divorce of the child’s natural parents. As we all know, divorce is not only difficult for the spouses, but is also difficult for the children. A lot of divorcing couples use their children to exact emotional or financial retribution. Predictably, a child who is cast into the middle of a nasty divorce is more likely to experience emotional problems. When the attention of one of their parents is diverted by a new spouse, it is not surprising that the child may become closer to their parent who does not remarry.

If you have gone through a divorce, and are considering disinheriting one of your children from a prior marriage, you should make allowances for the fact that your divorce created difficulties for your children. If your parents go through a divorce, my advice to the children is to continue to honor both of your parents and do the best you can to avoid taking sides in disputes between your parents. Your parents will take note if they perceive that you are teaming up against them.

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

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

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

Part 1: Use It or Lose It

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

Part 3: When Should You Make the Gift?

Part 4: Will a Large Gift Demotivate Your Children?

Part 5: Tennessee Gift Tax Clawback

Part 6: Tennessee Gift Tax Clawback Solutions

Part 7: Life Insurance Can Pay Tennessee Gift Tax Clawback

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

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

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

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

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

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

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

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

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

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

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

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

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

          Part 1: Use It or Lose It

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

          Part 3: When Should You Make the Gift?

          Part 4: Will a Large Gift Demotivate Your Children?

          Part 5: Tennessee Gift Tax Clawback

          Part 6: Tennessee Gift Tax Clawback Solutions

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

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

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

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