THE
2001 TAX ACT: A STATUS REPORT
As
we reported last year, the 2001 Tax Act contained
a number of transfer tax benefits which would be phased
in over an eight-year period. Ultimate repeal of the
Federal Estate and GST taxes is promised in 2010.
However, because the Senate was unable to pass the
Act with a super-majority of 60 votes, the 2001 Tax
Act, with the promised repeal of these taxes, sunsets
in 2011. That means that the repeal will only last
for one year (2010), and then the Federal Estate Tax
and GST taxes will come back into effect in 2011.
There
have been several attempts to make the above-described
repeal of the Federal Estate and GST taxes permanent
by bringing these matters before Congress again and
attempting to obtain 60 votes in the Senate. Those
attempts have failed. The 2001 Tax Act was passed
in June 2001 when we had an approximate $100 billion
national surplus. Since that time, we have had an
economic downturn and presently have an approximately
$200 billion deficit. Further, war is on the horizon.
Critics of repeal point out that the Federal Estate
tax was initially enacted in order to fund the expenses
of war.
This
year's elections have given the Republicans control
of the United States Senate. However, due to the Byrd
Rule and the filibuster power, sixty Senate
votes will still be needed to make the Federal Estate
and GST Tax repeal permanent. Many commentators speculate
that instead of repeal becoming permanent, an eventual
compromise will be reached. They speculate that this
will result in a substantially increased estate tax
applicable credit exclusion at the level of $2 million
or $3.5 million and a significant rate reduction.
FOUR
EXCELLENT APPROACHES FOR ESTATE PLANNING IN A LOW
INTEREST RATE ENVIRONMENT
We
are all aware of the present very low interest rate
environment. It is wonderful if we are applying for
equity loans or refinancing our mortgage. On the other
hand, it is painful for our fixed income accounts
such as money markets or new bond purchases. However,
these low interest rates present great opportunities
for the use of certain estate freeze techniques.
To
put this into perspective, in January 1989, the interest
rate we used for certain estate freeze techniques
was 10%. In November 2002, the interest is 3.6%. Let
us look at four of these techniques:
1.
Gift to Charity of a Remainder Interest in a
Personal Residence. Here, the donor deeds
his/her personal residence to charity, reserving the
right to live in the house for the remainder of the
donor's lifetime. An income tax deduction is available
for the actuarial value of the remainder. The lower
the applicable interest rate at the time of the gift,
the greater the income tax deduction.
For
example, assume you have a residence with a fair market
value of $500,000, one-half of which is attributable
to the house and one-half is attributable to the land.
You are seventy years old and desire to contribute
your house to your favorite charity after you die.
If you accomplish this transaction in November 2002
(when the required interest rate is 3.6%), you will
obtain an income tax charitable deduction of $350,222
which you can use to offset against your taxable income
in 2002 and future years. Compare this to the situation
where you made such a gift when the required interest
rate was 10%. In that case, your income tax charitable
deduction would only have been $205,985.
2.
Grantor Retained Annuity Trust. Assume you have
$1 million of assets which you anticipate will grow
at approximately 10% per year. You contribute these
assets to a GRAT. In exchange, the trustee of the
GRAT will pay you annuity payments over a ten-year
period which will equal $1 million plus interest (3.6%
per year if the GRAT is established in November 2002).
The recent Sam Walton Tax Court case establishes that
no gift occurs when you create such a zeroed-out GRAT.
At the end of the ten-year period, due to the 10%
per year growth, $457,364 will be left in the GRAT.
These assets will then be transferred to your beneficiaries
or to an Alaska Self-Settled Discretionary Spendthrift
Trust, of which you can be a discretionary beneficiary.
(See the discussion of these trusts, below.)
The
reason that we have $457,364 left at the end of the
ten-year period is that this is the growth amount
resulting from the difference of the 10% growth and
the low 3.6% required interest rate. You can see that
if this interest rate were high (for example, the10%
that existed in 1989), then no amount would be left
in the trust at the end of the ten-year period. Therefore,
low interest rates make GRATs a very valuable technique
for estate tax reduction.

The
annuity payments can be designed so that they increase
by 20% each year. This allows for lower annuity payments
in early years and higher ones in late years. As a
result, more of the growth is kept in
the trust at the end of the fixed term.
If
the trust does not have cash to make the payments,
the trustee can return some of the assets as payment
in-kind.
A
strong advantage of a GRAT is that it is expressly
authorized by the Internal Revenue Code and its regulations.
The zeroed-out benefit has been provided
by the recent Sam Walton Tax Court case.
The
disadvantages of a GRAT are that you have to live
the fixed term (ten years in the above example) for
it to work. If you die during the fixed term, the
assets are included in your gross estate and taxed
under the Federal Estate tax. Also, you cannot allocate
GST exemption to the GRAT until the end of the fixed
term.
3.
Sale to Grantor Trust. A similar popular technique
is an installment sale to a grantor trust. Assume
$1 million of assets is sold to the trust in exchange
for interest-only payments for nine years, and a balloon
payment at the end of the nine-year period. If the
trust does not have cash to make the payments, the
trustee can return some of the assets as payment in-kind.
Since you are selling the assets for their full fair
market value, again, no gift occurs. The lower the
interest rate, the lower the interest-only payments
during the ten-year period. All of the growth of the
assets (assumed to be 10% per year) in excess of the
interest rate (3.6% if the sale occurs in November
2002) will remain in the trust at the end of the payment
period. These assets will be transferred to your beneficiaries
or to an Alaska Self-Settled Discretionary Spendthrift
Trust, of which you can be a discretionary beneficiary.
The
trust is called a grantor trust because
you have retained certain administrative powers. Because
of your retention of these powers, present law provides
that all income and deductions of the trust are taxed
to you. To state this another way, there can be no
taxable events between you and the trust. As a result,
no capital gain tax is payable upon the sale of the
assets to the trust, and the interest income is not
taxed.
If
the trust does not have cash to make the payments,
The amount left in the grantor trust at the end of
the fixed term (nine years, here) will be very similar
to the amount left in the GRAT example described above.
Again, this amount is so large because of the substantial
difference between the assumed growth rate (10%) and
the required interest rate (3.6% for a sale to a grantor
trust in November 2002).
It
is important to recognize that the growth rate may
be much larger than what you assume, if the asset
value was discounted when it was contributed to the
GRAT or sold to the grantor trust. For example, assume
that you had first contributed $2 million of assets
to a family limited liability company. Your appraiser
determined that the value of the limited liability
company interests are subject to a fifty percent discount
because of minority interest, lack of marketability,
and the restrictions of the family limited liability
company entity. As a result, the assets in the GRAT
or the grantor trust, are really $2 million and would
produce growth that would be approximately
twice the 10% assumed above. This makes the GRAT or
grantor trust doubly effective.
The
advantages of the sale to grantor trust technique
are that the grantor does not have to survive the
fixed term for the transaction to work. Also, GST
exemption can be allocated to the trust at the time
of formation rather than waiting until the end of
the fixed term. Further, the interest rate is lower
than that used for a GRAT.
The
disadvantages of the sale to grantor trust technique
are that it is not based on a specific statute and
regulations. Rather, it is based upon a series of
authorities which tax planners have put together to
support the entire approach. Also, either a gift of
approximately 10% of the value of the assets sold
or a guarantee of that amount needs to be made in
order to establish the validity of the
trust before it purchases the assets.
4. Charitable Lead Trust. This approach
allows charitably inclined grantors to provide significant
current charitable benefits as well as save substantial
estate taxes. A charitable lead trust is similar to
a GRAT, with the annuity paid to charity instead of
being retained by the grantor. For example, assume
that you contribute $1 million of assets to a CLT.
Each year, the trustee will pay $120,848 to the charity
you have chosen. These annuity payments equal $1 million
plus 3.6% per year (the November 2002 interest rate).
As a result, there is no taxable gift when this trust
is created. Assume that the assets in the trust grow
at 10% per year. At the end of the ten-year period,
$667,737 will be left in the trust. These assets can
be transferred to your beneficiaries or to an Alaska
Self-Settled Discretionary Trust, of which you may
be a discretionary beneficiary.
Again,
these remaining assets are so large because they represent
the difference between the assumed 10% growth rate
and the required interest rate (3.6% for November
2002). Our planning is designed to take advantage
of the great difference between these two rates due
to the very low interest environment we are presently
experiencing.
A
charitable lead trust is very popular in a low interest
environment. It provides you with the opportunity
to make charitable contributions now to your favorite
charities, to your private foundation, or to a donor-advised
fund with a public charity such as a community foundation.
A
charitable lead trust is not income tax exempt. However,
the income earned by the trust each year is offset
by the charitable deduction obtained when the income
is distributed to charity as the annuity payment.
Charitable
lead annuity trusts are reportedly the technique used
by Jacqueline Onassis in her estate planning.

ALASKA'S FIVE-YEAR EXPERIENCE WITH SELF-SETTLED
DISCRETIONARY SPENDTHRIFT TRUSTS.
Number of Trusts Created. In 1997, Alaska was
the first state to enact a usable statute authorizing
self-settled discretionary spendthrift trusts (SSDS
Trusts). In addition, Alaska made its first
attempt to abolish the rule against perpetuities,
so as to allow for the formation of Alaska perpetual
trusts. Five years have elapsed. For the period from
1997 to the present, the following experience has
been reported.
Alaska
trustees state that approximately 870 trusts have
been formed under Alaska law by nonresidents of Alaska.
Of these, approximately 310 are SSDS Trusts, and the
balance are perpetual trusts. Most of the SSDS Trusts
also used a perpetual trust plan. Approximately 110
attorneys provided the legal services for the creation
of these trusts.
Alaska
estate planning attorneys report that approxi-mately
125 SSDS Trusts have been formed for Alaska residents.
In addition, 200 to 300 perpetual trusts have been
created for Alaskans. Several lawyers report that
their standard default plan for medium
and large estates now is based upon a perpetual trust
dispositive plan. Approximately sixty percent of both
the resident and nonresident SSDS Trusts have involved
contributions of assets which were completed gifts
for federal gift tax purposes.
The
following example of a planning dilemma
illustrates the use of SSDS Trusts for transfer tax
reduction planning.
The
Planning Dilemma: Early Gift Giving Versus Future
Possible Needs. Consider this planning situation:
you are a couple in your fifties. One or both of you
is a small business owner, executive, or professional.
Your net worth is in the range of $3 million to $10
million. Substantial estate taxes could be saved if
you made annual exclusion and applicable credit gifts
to irrevocable trusts for your children and/or grandchildren.
The gifts could be structured so that they qualify
for valuation discounts, and the growth of the gift
assets would be excluded from your estates. Based
on your net worth and your anticipated future earnings,
it appears that these gifted amounts would not be
needed by you. Nevertheless, you are reluctant to
give away significant assets at this point in your
life. You might need these assets in the future if
you have an unexpected financial reversal.
You
ask if you can be added as discretionary beneficiaries
of the trust. Then, the trustee can make distributions
to you if needed. Before Alaska's law was changed,
if you were added as discretionary benefi-ciaries,
the IRS could successfully argue that the trust assets
should be included in your gross estate at death and
be taxed under the Federal Estate Tax.
The
reason is that before 1996 all states had a statutory
or case law policy that provided that if the settlors
are discretionary beneficiaries of the trust, the
settlors' creditors can reach the maximum amount that
the trustee could distribute to the settlors and,
in many instances, this would be all of the assets
in the trust. Therefore, the settlors could run
up debts and the settlors' creditors could reach
the trust assets to satisfy these obligations. Another
way of looking at the situation is that the settlors,
indirectly, have retained ability to reach the trust
assets through incurring debts.

This
indirect retention of the use of the trust assets
prevents the settlors' transfers to the trust from
being completed gifts for gift tax purposes. Moreover,
such indirect retention would result in the trust
assets being included in the settlors' gross estates
under Internal.
Alaska's
Statutory Change Provides a Solution. In
1997, the Alaska Legislature changed Alaska law to
authorize the use of SSDS Trusts. The new legislation
provided, in effect, that under Alaska law a settlor
may create an irrevocable trust, transfer assets to
it, be a discretionary beneficiary of such trust,
and yet, the settlor's creditors cannot reach the
assets in such a trust.
From
a transfer tax standpoint, because the settlor's creditors
cannot reach the assets in the trust, the settlor's
ability to incur debt does not give the settlor dominion
and control over the trust assets. Accordingly,
the settlor's transfers to a SSDS Trust are completed
gifts. The IRS has agreed. In addition, proponents
of SSDS Trusts contend that none of the inclusion
provisions of the federal estate tax apply to the
assets in an Alaska SSDS Trust. The proponents' position
is that the settlor has not retained the enjoyment
or income from the assets (I.R.C. § 2036), nor
does the settlor possess at death the power to alter,
amend, revoke, or terminate the transfer (I.R.C. §
2038). Hence, the trust assets should be excluded
from the settlor's gross estate.
As
a result, you may create an Alaska SSDS Trust, make
annual exclusion and applicable exclusion amount gifts
to the trust, and be included in the class of discretionary
beneficiaries to whom an independent trustee may make
distributions. A strong position exists that such
assets will not be included in your gross estates
at your deaths. In addition, if you need funds in
future, due to an unexpected financial downturn, the
trust assists are available.
Your
Question: A Comparison of a Private Foundation with
a Donor-Advised Fund
More
and more of our clients have been asking us to provide
information about charitable planning techniques and
vehicles. We are often asked whether a family should
use a private foundation or a commonly used substitute,
a donor-advised fund. Here is a summary of the differences
between these charitable vehicles.
Private
Foundation. Several steps are necessary in order
to create a private foundation. First, a non-profit
corpora-tion is formed under Alaska law. Then, a thorough
and detailed application is prepared and submitted
to the IRS requesting tax-exempt status for the foundation.
The IRS reviews the application and contacts you several
times for clarification and additional materials.
Usually, it takes six months or more to obtain the
desired tax-exempt status.
You
and your family may manage and control your family's
private foundation. You can decide upon the charitable
recipients of the foundation's annual distribu-tions.
Further, you and your family members can be employed
by the foundation, pursuant to IRS guidelines. These
are significant advantages of a private foundation.
Each
year, a private foundation must distribute 5% of its
total assets. Careful recordkeeping is necessary,
and annual tax reporting is required. The Internal
Revenue Code contains a number of prohibited
transactions which need to be carefully avoided.
An annual federal excise tax of up to 2% of the assets
of the foundation applies.
You
will receive an income tax deduction for assets which
you contribute to your private foundation. The amount
of the deduction depends upon the type of asset contributed:
Cash (30% of adjusted gross income);
Publicly traded securities (20% of AGI);
Restricted stock and real estate (20% of AGI).
There
is a 100% gift and estate tax charitable deduction
for assets which you transfer to your foundation.
A
private foundation does involve significant startup
and maintenance costs. As a result, this approach
is not used unless assets of approximately $500,000
are anticipated to be contributed to the foundation.
Donor-Advised
Fund. Instead of being a separate entity,
a donor-advised fund is a fund that you establish
with an already existing public charity. Often the
public charities chosen are community foundations
because they allow for a broad range of charitable
distributions. The donor-advised fund is owned and
controlled by the public charity. However, the donor
acts in an advisory capacity with regard to investment
strategy and grant making. The donor advises the public
charity concerning distributions from the fund. While
the public charity is not required to follow the donor's
advice, generally it does so.
Because
the donor-advised fund is set up with an existing
public charity, it is much simpler to create and maintain.
You do not need to set up a non-profit corporation
or apply for tax-exempt status. Recordkeep-ing is
done by the public charity, and annual expenses are
significantly less. The IRS' prohibited transaction
rules do not apply to public charities nor does the
2% excise tax. You are not required to distribute
any of the fund's assets on an annual basis.
The
disadvantages of the donor-advised fund are that you
do not have legal control over investment and distribution
decisions. Rather, you give advice to the public charity's
board. Second, you and your family members cannot
be employed and compensated by the fund.
Since
you are contributing assets to a public charity, however,
you obtain superior income tax benefits. They are
as follows:
Cash (50% of AGI);
Publicly traded securities (30% of AGI);
Restricted stock and real estate (30% of AGI).
The
simplicity of a donor-advised fund is very attractive.
Such a fund can be created by merely executing an
agreement with the public charity. Depending on the
public charity, an amount as small as $10,000 to $50,000
may be accepted as contributions to the fund. Usually,
an annual fee of 1% to 1.5% of the fund assets is
paid to the public charity, which it uses to pay for
the expense of maintaining the fund. Any excess of
the fee is distributed by the public charity for charitable
purposes.
In
summary, both private foundations and donor-advised
funds are valuable tools for implementing charitable
giving. Both approaches allow you to accomplish charitable
giving during your lifetime and obtain significant
income tax benefits. Each year, you and your family
can participate in making the charitable giving decisions.
Younger members of your family can participate in
and enjoy the satisfaction of the charitable giving
process.
The
two approaches do differ in regard to the extent to
which you and your family will have legal control
over operation and distributions. The private foundation
provides such control and allows you and your family
members to be employed and compensated. However, as
described above, there are trade-offs in terms of
costs and restrictions which need to be considered.
Families desiring to accomplish significant charitable
giving need to carefully evaluate each approach and
decide which is the most appropriate for them.
