February 1998 - Recent Estate Planning Developments Last Half of 1997 and Early 1998

Recent Estate Planning Developments
Last Half of 1997 and Early 1998
David G. Shaftel 1998.
All rights reserved.
A Summary Provided by the: Law Offices of David G. Shaftel, PC

Many new federal and Alaska developments have occurred in the estate planning area during the last half of 1997. These developments are found in the Taxpayer Relief Act of 1997, recent case law, new IRS regulations and rulings, and Treasury Department proposals. Since a number of these matters were pending until very recently, we decided to wait before sending you this summary. Now it is appropriate to bring you up to date.

In this newsletter we will only describe, in general terms, the estate planning changes which we think will be most interesting to Alaskans. We will not try to go into the specifics of these sub-jects. Nor will we cover the numerous technical changes that apply to very limited situations

As always, it is important for you to periodically review your own estate planning situation. You should consider not only the changes in the law, but also your personal financial and family situation. Our office, your accountants, and your other financial advisors are always available to review the specifics of these changes with you, as they apply to your personal estate planning.

Now let's review a number of the important developments which have recently occurred and affect us here in Alaska:

1. TREASURY DEPARTMENT PROPOSALS TO ELIMINATE THE VALUATION DISCOUNT BENEFITS OF FLPs AND FLLCs, ELIMINATE RESIDENCE TRUSTS, AND ALSO "CRUMMEY" WITHDRAWAL POWERS. The Administration's very recently released new budget includes these proposals. If enacted, the valuation discount benefit of family limited partnerships and FLLCs would be eliminated except for active businesses. Surprisingly, the Administration also wants to end residence trusts, which were expressly authorized by Congress in 1990. That legislation allowed you to gift your residence to a trust, and then retain the use of the residence for a number of years. After this term expires, ownership of your residence goes to your desired beneficiaries (e.g., your children). This type of trust allows you to transfer your residence to children or grandchildren for a gift based on a very small fraction of the residence's value. A third proposal, elimination of "Crummey" powers, would prevent annual exclusion gifting ($10,000 gifts) to most trusts.

Comments: These new proposals are slated to become effective on the date of enactment. The Republican Congress may well reject them. However, it is always difficult to predict what will happen in the "give and take" of the legislative process. If you are interested in taking advantage of these techniques, you should consider doing so immediately.

2. APPLICABLE CREDIT AMOUNT. This is the new name given to what we know as the "unified credit." In 1997, this tax credit allowed each person to transfer $600,000 of property during lifetime or at death without having to actually pay any gift or estate tax. The credit has been constant since 1986. Now, Congress has decided to slowly increase the credit so it will protect the following transfers:

$ 625,000
$ 650,000
2000 and 2001
$ 675,000
2002 and 2003
$ 700,000
$ 850,000
$ 950,000
2006 or thereafter

Comments: For medium and large estates, it is almost always better to use this ability to transfer property tax-free during your lifetime, rather than waiting until your death. Early use of this tax-free transfer allows you to keep the gifted properties' appreciation out of your gross estate. There are various ways to get the most out of this lifetime gifting, including the use of certain types of trusts, family limited partnerships, and family limited liability companies.

3. FUTURE INCREASES IN THE ANNUAL EXCLUSION AND THE GST EXEMPTION. The annual exclusion allows a person to gift up to $10,000 each calendar year to as many donees as desired. This $10,000 amount will be adjusted for inflation after 1998. The adjustment will only occur in increments of $1,000. Therefore, the annual exclusion will not increase from $10,000 to $11,000 until the cost-of-living adjustment totals at least 10%. This may take several years.

Comments: Annual exclusion tax-free gifting is a "use it or lose it" tax benefit. This annual gifting should be considered by everyone who has or anticipates that they will have a net worth that will result in the payment of some estate tax.

The generation-skipping transfer exemption presently allows each person to exempt $1 million of property from the generation-skipping transfer tax. After 1998, this amount will also be adjusted for inflation. Here the adjustment will only be made in $10,000 increments, when the cost of living adjustment total so dictates.

Comments: Generation-skipping trusts have become popular. Either during lifetime or at death a trust is set up and funded with up to $1 million from one or both spouses. GST exemption is allocated to the trust totally exempting it from future GST tax. This trust can benefit the family's children and their descendants. It will only be subject to transfer tax once: the estate tax when the older generation dies. It will never be subject to estate tax again. In Alaska, these trusts can continue in perpetuity.

4. FAMILY OWNED BUSINESS EXCLUSION. This anticipated new provision has been highly publicized over the past several years, but has turned out to be very disappointing. This new statute was supposed to provide substantial transfer tax relief for small business owners. Instead, the finalized provision has turned out to be exceedingly complex, and its requirements will be very difficult to satisfy. Both the American Bar Association and the American College of Trust and Estate Counsel have recommended that it be repealed and that Congress start anew.

However, for the time being we have this new IRC §2033A, which is summarized, very generally, as follows. When this provision applies, it will exclude from the decedent's gross estate an amount equal to $1,300,000 less the present amount of the applicable credit. Therefore, in 1998 $1,300,000 less $625,000 equals a $675,000 family owned business exclusion. In the year 2006, $1,300,000 less a $1,000,000 applicable credit will equal a $300,000 family owned business exclusion.

The decedent and members of the decedent's family must own at least 50% of the business entity involved. During five of the eight years before the decedent's death, the decedent or a member of his family must have "materially participated" in the business. An election must be affirmatively made to qualify for the exclusion, and an agreement entered into such that if a recapture event occurs then the recaptured tax will be paid. If, within the period of ten years after the decedent's death, the heir who received the business interest disposes of the business interest, or material participation ceases by the heir or a member of the heir's family in the business, then a percentage of the tax saved by this exclusion is recaptured.

Comments: You should consider whether your situation involves a business interest that may qualify for this family-owned business exclusion. Do you and your family own more than 50% of a business? Will a member of your family continue to materially participate in this business after your death? If so, then your situation should be evaluated in the future to determine if you meet all of the other technical requirements for this exclusion. If you do, then your wills or revocable trusts will probably need some redraft- ing. Further, here in Alaska, it may be desirable to split the business interests between husband and wife so that each may qualify for the exclu- sion. You may want to wait until the end of 1998 to see if substantial changes to this provision are made in the anticipated 1998 Tax Act.

5. REVOCABLE TRUSTS TREATED THE SAME AS ESTATES FOR INCOME TAX PURPOSES. As we have discussed, revocable trusts have a number of non-tax advantages as compared to wills. They have become very popular here in Alaska, as they have in most states. However, after death the income tax treatment of a revocable trust has been somewhat inferior to the treatment of an estate resulting from a decedent who used a will. The recent tax act changes make the income tax treatment of these entities almost the same. New IRC §646 allows the trustee and personal representative to elect to treat a decedent's revocable trust as part of the decedent's estate. This treatment will continue for a period of four years and three months. The overall consequences of this election, plus other estate income tax changes, may be summarized as follows.

a. Fiscal Year. A fiscal year can now be used by a revocable trust, as has always been the case for an estate.

b. Permanent Set-Aside For Charitable Deductions. All estates and trusts have been allowed to take deductions for amounts actually paid to charity. In addition, estates could deduct an amount that was set-aside for a future charitable payment. Now revocable trusts can also take advantage of this flexible technique.

c. Real Estate Passive Activity Losses. Estates have been allowed to deduct up to $25,000 of real estate passive activity losses if the decedent has "actively participated." It has been unclear whether this benefit applied to property held in revocable trusts. Now this benefit is available to revocable trusts.

d. Shareholder Of "S" Corporation. Previously, S-corp stock could only be held by a revocable trust for two years after the decedent's death. Now, such stock can probably be held for the entire §646 election period, which is four years and three months.

e. Sixty-Five Day Rule Extended To Estates. Trusts can elect to treat distributions to beneficiaries made within 65 days after the close of the trust's taxable year as if they were made during the taxable year. This allowed for planning flexibility after the close of a taxable year. This planning flexibility has now been extended to estates.

f. Separate Share Rule Now Applicable To Estates. Substantially separate and independent shares of different beneficiaries in a trust have been treated as separate trusts for income tax purposes. This rule is now extended to estates. This change will have the effect of reducing the income tax planning flexibility of estates.

g. Related Party Rules Disallowing Losses. Trusts and beneficiaries are treated as related parties, so that losses on sales between such parties are not allowed. This disallowance rule is now also applied to estates and beneficiaries of the estate.

Comments: This equalization of the income tax treatment of revocable trusts and estates, after death, makes revocable trusts an even more attractive vehicle for estate planning.

6. GIFTS FROM REVOCABLE TRUSTS. In the past, the IRS often challenged gifts which were made directly from revocable trusts, if the donor died within three years of the date of making the gift. The IRS argued that then the gift must be included in the decedent's gross estate under IRC §2035. Substantial litigation resulted from this IRS position. Now Congress has eliminated this tax trap. A gift from the revocable trust will now be treated as a gift directly from the grantor of the trust, and therefore IRC §2035 will not apply.

7. GIFT TAX STATUTE OF LIMITATIONS. The gift tax statute of limitations generally requires that the IRS can only attempt to assess additional gift tax within three years after the filing of the gift tax return. Previously, the amount of a particular gift would be reported on the return, but it was not neces- sary to provide additional information. Now, the new law requires that in order to begin the running of the limitations period on the value of the gift it must be disclosed in a manner adequate to apprise the IRS of the nature of the item.

Comments: Often you will want to put the IRS in a position of either challenging the value of your gifts now, or be foreclosed from challenging such value in the future. If so, then you need to adequately disclose the nature of each gifted property reported on the return. Otherwise, the IRS will be able to challenge these values and attempt to increase the gift tax and possibly even your estate tax marginal rate, even after your death during the estate tax audit.

8. CAPITAL GAIN RATE REDUCTION. Everyone is familiar with this change. In general, low income taxpayers who are in the 15% bracket will have their capital gains taxed at 10%. Higher income taxpayers will have a 20% capital gains maximum rate. To qualify for these rates, the taxpayer must have held the capital asset for at least 18 months.

Comments: When we gift property for estate planning purposes, the basis of the property carries over to the donee. When the donee subsequently sells the property, capital gain results. If the decedent had instead held the property until death, a step-up in basis would occur which would avoid the capital gain from being realized on a subsequent sale by a beneficiary. This disadvantage of gifting is almost always greatly outweighed by the fact that failure to gift the property will ultimately produce estate tax at higher rates than the capital gain rates. The new Tax Act's reduction in the capital gain rates makes this difference even greater. The bottom line: it is now even more important to consider a substantial gifting program during life.

9. SALE OF PRINCIPAL RESIDENCE EXCLUSION. Under pre-1997 law, a taxpayer could generally sell a principal residence and then buy a new principal residence, and defer recognition of any capital gain. Further, a taxpayer could sell his principal residence and exclude $125,000 of gain from recognition. These provisions have been repealed in exchange for a much more generous exclusion provision. Now, every two years an individual taxpayer can exclude $250,000, and a married couple can exclude $500,000, from capital gain recognition upon the sale of a principal residence. The taxpayers must have lived in the residence for at least two out of the last five years.

Comments: This new provision is important for estate planning purposes. Often, after the children grow up and leave home, a couple will downsize their residence. This provision will often allow a family to liquidate their principal residence without incurring any income tax. The resulting funds can then be used for other estate planning purposes.

10. VALUATION DISCOUNT PRODUCED BY FAMILY LIMITED PARTNERSHIPS AND LIMITED LIABILITY COMPANIES. When limited partnership interests or limited liability company interests are transferred by gift or at death, appraisers generally conclude that their value should be significantly discounted. Depending on the entity, state law, and the type of assets held, these appraised discounts vary from 30% to 70%. In recent years, the IRS has become concerned about abuses in this area. As we described in our prior client letter, one of the attacks used by the IRS was to argue that IRC §2703 applied to disallow all such discounts. However, in recent Tax Court litigation, the IRS has backed off of this attack. Other cases now pending in Tax Court will be closely watched to see if this is an overall concession by the IRS.

Comments: Valuation discount resulting from gifting FLP or FLLC interests has become very popular. Reports at national estate planning institutes indicate that audit experience has generally been favorable. As we discussed in our prior letter, 1997 Alaska legislative changes have made Alaska FLPs and FLLCs superior to those of most other states. However, the IRS is concerned about the creation of valuation discount in family situations involving investment assets. This concern produced the Treasury's proposals for legislative change (see paragraph 1, above).

Further comments: Many clients have chosen to use family limited partnerships and family limited liability companies for reasons other than obtaining valuation discount. These entities allow you to place a variety of real estate, partnership interests, and security investments in one place. This allows for ease in gifting fractional interests, in the form of percentage partnership or LLC interests, to children and grandchildren. The older generation can retain control of the management and investment of these properties by being the general partners or managing members of the entity. Also, these types of entities provide substantial protection from creditors.

11. LIMITED LIABILITY COMPANIES ARE BECOMING THE ENTITY OF CHOICE. As we have previously discussed, a limited liability company is taxed as a partnership, rather than a corporation. Partnership taxation is generally considered a more favorable and flexible approach than corporate taxation. In addition, an LLC provides limited liability for all of its owners. Therefore, these entities combine the best of both partnerships and corporations. The new "check-the-box" regulations issued by the IRS now allow for solely-owned limited liability companies.

Comments: For estate planning purposes, family business or investment activities owned as a limited liability company are much preferable to those owned as an S-corporation. S-corporation stock can only be owned by certain types of trusts, and cannot be owned by a family limited partnership or a family limited liability company.

12. ALASKA TRUSTS--PRIVATE LETTER RULING REQUEST PENDING. In our prior client letter, we reported to you about the new type of trust authorized by the Alaska legislature. An open question concerning these trusts is whether settlors could make completed gifts to these trusts, and still be beneficiaries themselves. A private letter ruling request has been filed with the IRS. The IRS will state its position in the near future.

13. 1998 STATE OF ALASKA LEGISLATION. Alaska estate planners are working with their legislators to facilitate the enactment of sophisticated administrative provisions for trusts and estates. In addition, new legislation will hopefully clarify and improve certain technical provisions relating to limited partnerships and limited liability companies.

14. QUALIFIED CONSERVATION EASEMENT. A personal representative is allowed to elect to exclude from the gross estate 40% of the value of any "land subject to a qualified conservation easement." This provision was enacted pursuant to the theory that it will ease existing pressures to develop or sell off open spaces in order to raise funds to pay estate taxes. The exclusion is phased in between 1998 and the year 2002, reaching a maximum amount of $500,000 of value which may be excluded.

15. REPEAL OF 15% EXCESS DISTRIBUTION AND EXCESS RETIREMENT ACCUMULATION TAX. Retirement accounts have become an increasingly important asset of many persons. These accounts are subject to both the income and estate tax. In addition, prior law had applied a third tax: a 15% excise tax upon distributions which exceeded a certain amount, and on accumulations which exceeded a certain amount at death. This third tax is now repealed.

Comments: As discussed immediately above, these accounts often form a substantial amount of a person's net worth. As a result, estate planning analysis of these accounts, and the selection of appropriate beneficiaries of such accounts, have also become very important. Depending on the circumstances, the best choice of beneficiary of such an account may be a surviving spouse, children, the bypass trust, the marital trust, the revocable trust, other trusts, or your favorite Alaska charity. This aspect of your estate planning deserves careful analysis.

16. CONTRIBUTIONS OF APPRECIATED PUBLICLY TRADED STOCK TO PRIVATE FOUNDATIONS. Taxpayers have been allowed a charitable income tax deduction for the full fair market value of publicly traded stock contributed to public charities. However, as a general rule, taxpayers were only allowed to deduct their basis for contributions of such properties to private foundations. Interestingly, Congress has permitted short-term exceptions to this restricted private foundation rule. These exceptions have been extended through July 1, 1998. That is, contributions of publicly traded stock will produce full fair market value charitable income tax deductions whether made to public charities or to private foundations.

17. ROTH IRAs. A new type of IRA has been created. Contributions to a Roth IRA are non-deductible, and if certain conditions are met, distributions are tax-free. Generally, a contribution is limited to $2,000 per year. Unlike regular IRAs, there is an adjusted gross income limitation. The contribution that can be made to a Roth IRA is phased out for individuals with AGI between $95,000 and $110,000, and joint filers with AGI between $150,000 and $160,000. Regular IRAs can be converted to Roth IRAs. Generally, such a conversion will produce ordinary income equal to the amount converted.

Comments: Your accountant or other retirement plan advisor can assist you in analyzing whether your existing IRA should be converted into a Roth IRA. The obvious advantage is that when distributions are taken out of a Roth IRA, they will be tax-free.

These have been the estate planning highlights of the last half of 1997 and early 1998. If you have questions about these or other estate planning matters, please contact us for an appointment. We remain available to assist you and your family.