Last week, the IRS issued proposed regulations that will significantly reduce valuation discounts for gifts or sales of interests in family limited partnerships, family limited liability companies, and closely-held corporations.  It will take years and several court cases to determine the overall effect of the regulations.  My best guess is that the regulations will reduce the valuation discount for a typical family limited partnership gift or sale from approximately 35% to approximately 5% or 10%.

These regulations were issued pursuant to a statute that was enacted in 1990.  The reason the IRS waited so long to promulgate these regulations is because they preferred for Congress to change the law.  They have given up on Congress.  The regulations may eventually be ruled to be invalid for exceeding the statutory authority that was given to the IRS to promulgate these regulations.  Nevertheless, my advice is to plan as if the proposed regulations will be valid when issued as final regulations.  Trust me.  You don’t want to pay the legal fees to overturn the validity of IRS regulations.

When will the regulations become final?  We do not know for sure.  The IRS will hold hearings on the regulations on December 1, 2016.  Generally, it takes several weeks or months to finalize the regulations after the public hearings. The IRS will undoubtedly receive vociferous complaints from different groups around the country.

In summary, any planning transactions involving gifts or sales of family limited partnerships, family limited liability companies or closely-held corporations should be completed prior to December 1, 2016.

Effective January 1, 2016, the Tennessee inheritance tax has been repealed, based on a law that was enacted in 2012.  The repeal does not help individuals who died in 2015.  They are still subject to the tax.  It only helps families of decedents who die this year or later. 

What is the effect of the repeal?  First of all, the maximum estate tax rate for decedents who are above the federal estate tax exemption (currently $5,450,000) will only be 40%, rather than approximately 46%.  Even though this represents a significant reduction, I see little impact on whether you implement strategies to avoid federal estate taxes.  40% is still a steep rate and most of our clients want to take reasonable measures to minimize or eliminate the federal estate tax. 

The repeal will affect the design of documents prepared for our married clients.  For many years, our documents have created two credit shelter trusts, a typical credit shelter trust (often referred to as a “Family Trust”) for the amount of the Tennessee inheritance tax exemption, and a second trust (sometimes referred to as a “Tennessee QTIP Trust” or a “Tennessee GAP Trust”) equal to the difference between the federal estate tax exemption and the Tennessee inheritance tax exemption.  In 2015, this formula resulted in $5,000,000 going to the Family Trust and $430,000 going to the Tennessee QTIP Trust.  Fortunately, we can now place the entire federal estate tax exemption, currently $5,450,000, in the Family Trust and will not need a Tennessee QTIP Trust.

Do you need to modify your current documents that contain Tennessee QTIP Trust provisions?  In most cases, the answer is no.  The funding language for the Tennessee QTIP Trust will not apply since there is no Tennessee inheritance tax.  Feel free to modify your documents if it bothers you to have unnecessary language in your Will; however, my advice is to wait until you need to make a change for other reasons. 

A few surviving spouses have asked us whether they can eliminate a Tennessee QTIP Trust that was established by a spouse who died prior to 2016.  Unfortunately, it is not possible to merge the Tennessee QTIP Trust into the Family Trust.  The Tennessee QTIP Trust will still avoid federal estate taxes upon the surviving spouse’s death.  Thus, as a general rule, my advice is to maintain the Tennessee QTIP Trust.  If the surviving spouse’s estate has declined below the federal estate tax exemption, then it might be acceptable to liquidate the Tennessee QTIP Trust in whole or in part. 

The repeal of the Tennessee inheritance tax is a welcome change.  Most individuals do not need to make any adjustments to their estate planning documents or planning in light of this change.

I am currently working with an elderly client named John who is the beneficiary of a $6 million trust established by his father.  Upon his death, half of the trust will be distributed to his daughter; the other half will be distributed in equal shares to the children of his deceased son.  The trust owns a lot of stocks that were transferred to the trust upon his father’s death in 1989.  These stocks have a very low basis in comparison to the current fair market value of the stocks.  The trust is exempt from GST taxes and will not be subject to estate tax or GST tax upon his death.  Because the trust will not be subject to estate or GST tax, there will not be any change in the basis in the stocks of the trust upon his death. Therefore, when the daughter and grandchildren eventually sell the stocks, they will incur substantial capital gains taxes.  John would like for his daughter and grandchildren to receive a higher basis in the stocks, if that is possible. 

One approach is for the trust to distribute low-basis stocks worth approximately $3.4 million to John.  Since he already owns assets of $2 million, the distribution would give him a combined estate of $5.4 million, which is below the current federal estate tax exemption of $5.43 million.  His Will distributes his estate consistently with the trust.  Therefore, distributing assets out of the trust to John will not change the ultimate beneficiaries of the assets.  Because the stocks will be in his estate, they will receive a stepped-up basis upon his death. 

The danger with this approach is that the stocks will appreciate, which could result in estate taxes being owed upon John’s death.  Another danger is that the federal estate tax exemption could be decreased by future law change.  For example, the President has proposed a decrease of the exemption to $3.5 million. 

In order to accomplish John’s goals, while hedging against the appreciation and legislative risks, I have proposed the following solution:

Step One – The Trustee of the trust will establish a new trust that is identical to the 1989 trust, except that John will have a power in his Will to appoint a portion of the trust assets to creditors of his estate.  The amount that can be appointed will equal the maximum amount that does not result in estate taxes being payable.  The power of appointment will apply in sequential order to the most highly appreciated assets. 

Step Two – The Trustee of the 1989 Trust will distribute approximately $4 million in appreciated assets to the new trust.  Tennessee law allows the transfer of assets between trusts for the same beneficiaries in certain circumstances.  This process is referred to as “Decanting.”

The power of appointment will have the following consequences upon John’s death.  John does not have any creditors, therefore, there is very little risk that he will exercise his power of appointment in favor of creditors.  Even though the power is virtually meaningless, the Internal Revenue Code requires the amount that could be appointed to be included in John’s estate for estate tax purposes.  However, since the amount that can be appointed is limited to the amount that will not cause estate taxes, no estate tax will be owed.  Once the formula amount is determined, the Trustee will then determine which assets had the most appreciation and, thus, which assets are subject to the power of appointment.  These assets will receive a stepped-up basis upon John’s death.  His daughter and grandchildren would then be able to sell those assets without any capital gains (except for appreciation that may occur following John’s death).  Based upon the current disparity between basis and fair market value of the stocks in the trust, there would be approximately $2.7 million of additional basis gained by this technique.  John’s daughter lives in California (which has state income taxes on capital gains), while the grandchildren live in Tennessee.  Based upon the maximum federal and state income tax rates, the increased basis could reduce future income taxes by as much as $800,000.

Your $5.43 million federal estate exemption is a very generous gift that Congress has provided to you.  You should look for opportunities to leverage the exemption to give your heirs a higher basis for income tax purposes.

On April 14, 2014, the Tennessee Legislature approved a new type of trust known as a Tenants by the Entirety Trust (“TBET”).

A TBET is a joint trust for a married couple that provides the same protection from the claims of the separate creditors of the husband and wife as would exist if the husband and wife owned the trust assets directly as tenants by the entirety. 

Being able to transfer tenants by the entirety property to a TBET without sacrificing creditor protection will make it more feasible for couples to use revocable trusts for their various benefits, including incapacity management, probate avoidance, and privacy.

A TBET only provides creditor protection for property that was held by the spouses as tenants by the entirety property prior to the conveyance of the property to the trust.  The additional requirements of a TBET include: (1) the husband and wife must remain married; (2) the property must continue to be held in trust by the trustee(s) or their successors in trust; (3) while both the husband and wife are living, the trust must be revocable by either spouse or by both of them acting together; (4) both spouses must be beneficiaries of the trust; and (5) the trust instrument, deed, or other instrument of conveyance must specify that the provisions of the new statute apply to the property. 

Traditional tenants by the entirety property automatically passes to the survivor upon the death of the first spouse.  A TBET is more flexible.  For example, the TBET could convert to an irrevocable trust for the benefit of the survivor, with the remainder to pass to children after the survivor’s death.  This structure would provide better asset protection for the survivor as well as better protection to the children if the survivor remarries.

After the death of the first spouse to die, the property will continue to be exempt from the claims of the decedent’s separate creditors.  To the extent the survivor may withdraw the trust assets, the property will be subject to the claims of the survivor’s separate creditors.

Creditor protection may be waived as to any specific creditor or any specifically described trust property, but only if expressly permitted by the trust instrument, deed, or other instrument of conveyance or if the husband and wife both give their written consent.  This provision allows a house subject to a mortgage to be transferred to a TBET.

TBETs may be created on or after July 1, 2014. 

Tennessee adopted its decanting statute in 2004 and made improvements to the statute in 2013.  Decanting has allowed many of our clients to improve troublesome provisions contained in prior trust agreements.  There are now 22 states that have adopted decanting statutes.  I predict that all states will adopt some version of decanting within the next 10 years. 

Steve Oshins has compiled a ranking of the decanting statutes.  Tennessee ranks 5th on his list.  Two of the three areas where Tennessee loses points are misleading.  Tennessee does allow a trust with an ascertainable standard to be decanted into a discretionary trust.  Mr. Oshins correctly points that our statute does not allow a mandatory income interest to be removed.  We included this prohibition in the statute due to a concern that eliminating a mandatory income interest might create adverse income, gift, and generation-skipping tax results.

Attached is a decanting paper I presented last year when there were only 18 states that allowed decanting.

This is the second article of a series regarding 2014 Trust and Estate Planning

For the prior article, see:

PART 1:  Introduction

Trusts that are not treated as grantor trusts are now subject to income tax at much higher rates.  Trusts are taxed at the maximum individual income tax rates on all income beyond $11,950 for 2013 and $12,150 for 2014.  As a general rule, non-grantor trusts are taxed as follows: to the extent income is distributed to the beneficiaries, the beneficiaries are taxed; the portion of the income retained in the trust is taxed to the trust.  There is a special rule for capital gains, which generally makes capital gains taxable to the trust whether or not the proceeds are distributed to the beneficiary. 

When the beneficiary of the trust is not in the top income tax bracket, it is often possible to reduce overall income taxes by making distributions to the beneficiary.  This assumes that circumstances are appropriate for making distributions.  First, the trust must authorize the trustee to make the distributions.  Second, the beneficiary must not waste the distribution.  It is better to pay a high tax within the trust and keep the after-tax proceeds than to make a distribution and have it wasted by the beneficiary. 

There is a special election that allows the trust to treat distributions made within the first 65 days of the following calendar year as having been made in the previous calendar year.  Thus, if there is a beneficiary who is in a lower tax bracket and circumstances are appropriate for making a distribution to the beneficiary, the trust may be able to reduce its taxes for 2013 by making a distribution on or before March 5, 2014.

Due to certain rules that apply to individuals but not to trusts, the maximum tax bracket for individuals is slightly higher than the maximum tax bracket for trusts.  When the beneficiary is in the top bracket, it may work out better for the trust to pay tax on the income than for the beneficiary.  If circumstances warrant, consideration should be given to accumulating income within the trust.  If income is distributed within the 65-day period, the trust is not required to treat it as having been made in the prior year.

In addition to the federal income tax consequences, state income taxes may also be relevant.  When the beneficiary lives in Tennessee, the Hall income tax will be paid whether or not a distribution is made.  However, if the beneficiary lives in another state, Tennessee taxes will not be payable.  Whether or not taxes are paid to the beneficiary’s state of residence may depend on whether or not distributions are made from the trust.

As you can see, the timing and amounts of trust distributions can affect the amount of federal and state income taxes that are paid.  You should analyze these opportunities now in case distributions need to be made prior to March 6, 2014.

2013 was a year of tremendous change in the estate planning field.  The American Taxpayer Relief Act of 2012 (“ATRA”) gave us higher income tax rates, a “permanent” unified estate, gift, and generation-skipping transfer tax exemption of $5 million indexed for inflation, portability of the estate tax exemption, and an estate tax rate of 40%.  The Affordable Care Act imposed a new 3.8% tax, the Net Investment Income Tax (“NIIT”), on many types of passive income received by high-income taxpayers.  Finally, the Tennessee inheritance tax exemption increased to $1.25 million per person, with scheduled increases to $2 million in 2014 and $5 million in 2015 before this tax disappears in 2016.

The net effect of all these changes is that fewer people need to worry about estate and inheritance taxes.  For individuals who have more than $5 million, or couples who have more than $10 million, the higher estate and gift tax exemption and portability open up a lot of planning opportunities to reduce or eliminate estate taxes.

The news is not so good on the income tax side.  Most of you will be paying significantly more income taxes for 2013 and later years than you paid prior to 2013.

The combination of lower estate taxes and higher income taxes has led to a new tax environment in which some familiar planning techniques need to be discarded and new planning techniques have emerged.  In some cases, income taxes can be reduced by unwinding or modifying trusts or business entities that you previously established.  We will examine these new opportunities in a series of articles over the coming weeks.  

Last week, two clients scheduled appointments with me while their children were home for the holidays.  The goal of the meetings was to explain the parents’ estate plan to the children.  I did not disclose the extent of the parents’ net worth.  We discussed various trusts that would be established, the identity of executors and trustees, and the disposition of specific assets.  We also covered some premarital asset protection planning concepts.  Both meetings were positive.

I am often asked whether children should be informed about their parents’ estate plan and, if so, when is the appropriate time.  The answer is: It depends.

On the positive side, making sure that your children know about your estate plan can make things go smoother during your senior years and after you die.  As we are living longer, it becomes more likely that you will live for some period of time in which you need assistance from your children.  If they understand your overall plan, they can better carry out your wishes. 

Knowledge of your estate plan may assist your child with their financial or estate planning.  For example, if you have established a trust that gives your child a testamentary limited power of appointment, your child may want to exercise the power in a way that coordinates with the child’s estate plan.

On the negative side, if children are disappointed with their future inheritance they might whine or connive to change the outcome.  This might accelerate a stressful condition that would otherwise not manifest itself until after your death.  Your child may have a mental illness or might be married to a person whose family values differ markedly from your own.  Conversations about estate planning might be uncomfortable.  Some of my clients understandably have the attitude of “Why should I put up with that during my lifetime?”

Knowledge about a substantial future inheritance might cause your child not to realize their maximum potential.  In my practice, I have encountered children who seem to be waiting on their parents to die.  They expect that their parents will take care of the child’s retirement years, so the child does not work as hard.

Overall, I believe that sharing your estate plan with your children is healthy.  You need to judge when your children are mature enough to receive this information.  If you have a dysfunctional child, it may be best to wait until after your funeral.

 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.