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Tax Quote of the Week
"Although it often seems as though the drafters of tax statutes
delight in taxing people on the basis of what their advisers are likely to miss,
Congress has not explicitly adopted this as policy."
-- Lee A. Sheppard
Estate Tax -- Repeal in 2010 and Return in 2011
On December 3, 2009, the House passed the Permanent Estate Tax Relief for
Families, Farmers and Small Business Act of 2009. The act would make
permanent the $3.5 million estate tax exemption and the 45% estate tax
rate. It also continues the 2009 rules that permit estates to pass on
property with a stepped-up basis.
Due to the comprehensive effort to pass healthcare reform, the Senate did
not act on estate taxes at the end of 2009. As a result, the estate tax is
repealed on Jan. 1, 2010. The gift tax is retained with a 35% rate and
there is a step up in basis for estate assets valued at $1.3 million.
Because there is no step up in basis forestate estate assets over $1.3
million, children and other heirs of estates over that level who later sell
property may pay large capital gains taxes.
Rep. Earl Pomeroy (D-ND) supported the House bill to extend permanently the
$3.5 million exemption and 45% estate tax rate. He noted that the repeal of
the estate tax will result in larger capital gains taxes for many children
and other heirs. While about 6,000 estates would be subject to estate tax
with the $3.5 million exemption, Pomeroy projected that 61,000 estates in
2010 will be over $1.3 million. The heirs of 2010 estates over $1.3 million
may pay capital gains taxes if they sell the inherited property. If the
capital gains tax increases to 20% in 2011, sale of inherited assets could
lead to a substantial tax.
Under current law, the estate tax will be repealed in 2010 and return in
2011 with a $1 million exemption and 55% tax rate.
Will a 2010 Estate Tax Law Be Retroactive?
Because both Senate Finance Committee Chair Max Baucus (D-MT) and Budget
Committee Chair Kent Conrad (D-ND) favor an extension of the $3.5 million
exemption and 45% estate tax rate, Congress may take action on estate taxes
in 2010. Sen. Baucus stated on Dec. 16, 2009, "We clearly will work to
do this retroactively."
However, Sen. Blanche Lincoln (D-AR) and Sen. Jon Kyl (R-AZ) continue to
support a $5 million exemption and a 35% estate tax rate. Therefore, there
is still great uncertainty about the action Congress will take on estate
tax in 2010.
There are five realistic and potential options for House and Senate action
on the estate tax:
- Pass a permanent extension of the $3.5 million
exemption and 45% tax rate, retroactive to Jan. 1, 2010.
- Pass a one or two year extension of the $3.5
million exemption and 45% tax rate, retroactive to Jan. 1, 2010.
- Pass a one or two year extension of the $3.5
million exemption and 45% tax rate, effective as of the date of the
introduction of the bill. This would result in a short-term repeal of
the estate tax for the period from Jan. 1, 2010 to the date of the
bill.
- Fail to come to agreement, and permit the estate
exemption to return on Jan. 1, 2011 to $1 million and the estate tax
rate to 55%. This would result in a repeal of the estate tax for
2010, but will create a very large estate tax increase in 2011.
- Pass a at $2 million estate tax exemption and 45%
tax rate, retroactive to Jan. 1, 2010.
Editor's Note: As a result of this estate tax uncertainty, there is great
challenge for attorneys and individuals in creating estate plans. A
potential end result is an extension of the $3.5 million exemption and 45%
estate tax rate, but with Congress any of the five options are possible.
Retroactive tax bills have been upheld by the U.S. Supreme Court. While the
current estate tax rate is zero, attorneys and individuals must recognize
that a retroactive 2010 estate tax bill may apply the 2009 rules and
exemption to 2010 estates.
"Charitable Lid" Formula Approved
In Estate
of Helen Christiansen et al. v. Commissioner; No. 08-3844 (8th Cir. 13
Nov. 2009), the Court determined that a "charitable lid" formula
disclaimer was valid.
Helen Christiansen passed away and transferred a substantial estate to her
only child, Christine Christiansen Hamilton. The estate plan documents
permitted Christine to disclaim her portion in order to reduce estate
taxes. If she chose to disclaim, 25% of the disclaimed amount would be
transferred outright to charity and 75% would be transferred to a
charitable lead annuity trust with Christine as the remainder recipient.
The majority of the estate was a family ranch that was held in a family
limited partnership (FLP). Based on the claimed FLP discounts, the estate
was valued at slightly more than $6.35 million. Christine chose to
disclaimer the excess value over $6.35 million. This excess value was then
divided, with 25% to a charitable foundation and 75% to the lead trust. The
estimated funding for the foundation was $40,555, and the charitable lead
annuity trust would receive $121,655.
The Tax Court considered the disclaimer and held that the lead trust
disclaimer was not valid. Under Sec. 2518, a disclaimer is not valid if the
disclaimant is to receive a future benefit. Since Christine was the
remainder recipient under the lead trust and did not disclaim that
remainder, her disclaimer was invalid for tax purposes.
However, the estate and the IRS continued to dispute the validity of the
"charitable lid" disclaimer that would transfer excess valuation
outright to a qualified charity. The IRS claimed that formula created a
contingency for the charitable bequest that disqualified the deduction
under Reg. 20.2055-2(b)(1).
Second, the IRS noted that it is proper public policy to give incentive to
the IRS to audit estates. Because a successful "charitable lid"
audit by the IRS will merely increase the charitable interest and will not
result in increased estate tax, the IRS maintained that this formula was
void on public policy grounds.
The Court reviewed both issues. The first issue concerning a potential
contingency was determined by the Court to be inapplicable in the
Christiansen estate. The amount of the excess over $6.35 million that was
irrevocably transferred to charity was 25%. There was no future condition
or action that would remove the right to receive this amount. The only
question was a determination of value as of the moment of death. Therefore,
a "charitable lid" formula that vests the charity with a right
that cannot be removed is valid.
Second, the Court noted that the IRS does not exist for the purpose of
conducting audits; rather, it exists "to enforce the tax law."
While a charitable lid may "marginally detract" from the
incentive for the IRS to audit, there is no clear Congressional intent that
tax law is to be interpreted in order to maximize the IRS audit incentive.
The Court noted that an executor has a fiduciary obligation both to the
family and to the charities and is bound by that obligation. In addition,
the Court indicated that the charities are likely to make certain that
"the executor or administrator does not under-report the estate's
value."
Therefore, the "charitable lid" formula disclaimer was upheld.
Editor's Note: It remains to be seen how vigorously charities will
oppose the executor's valuations for charitable lid formula clauses. With a
substantial estate there is a considerable benefit to charity by actively
pursuing a larger share through reducing the discount for lack of
marketability. The IRS clearly feels that charities may not be as
aggressive in pursuing higher estate shares as it might prefer.
FLP Was a "Bona Fide" Sale
In Estate
of Samuel P. Black Jr. et al. v. Commissioner; 133 T.C. No. 15; Nos.
23188-05, 23191-05, 23516-06 (14 Dec 2009), the Tax Court upheld family
limited partnership discounts on a "bona fide" sale rationale.
Samuel P. Black was the initial claims manager for Erie Indemnity Company
(Erie). He was involved with the insurance company from 1927 until he
retired from the Board of Directors in 1995. Mr. Black acquired stock
steadily during his entire lifetime.
In 1988, he made gifts of Erie stock to his son and to trusts for his
grandsons. Because he was concerned that his son might experience a divorce
(he did in 2004), and because both grandsons were over age 20 and did not
have jobs and "were not even looking for one," he became
concerned that his family would sell Erie stock.
After consultations with his advisors, on March 2, 1993, Mr. Black, his son
and the trusts for his grandsons all contributed Erie stock to Black LP.
Black LP managed the holdings of Erie stock which grew from approximately
$80 million to $318 million by 2001 when Mr. Black passed away.
In 1998, Mr. Black transferred his 1% general partnership interest to his
son. At his death at age 99 in 2001, he owned approximately 77% of Black
LP. Mrs. Black passed away five months later. Under the Black revocable
trust, her marital trust would have been funded with a substantial portion
of the Black LP interest.
The Black estate was able to pay the estate tax for Mr. Black, but treated
the marital trust as funded and therefore faced a very large estate tax
payment for the estate of Mrs. Black. A secondary offering of Erie stock by
the Black LP was permitted and it produced net proceeds of approximately
$98 million. Black LP lent the estate of Mrs. Black $71 million to pay
estate taxes and received interest payments from her estate on that loan.
The IRS audited and claimed the Black LP should be valued not at the
discounted value, but at the full fair market value of the underlying
stock. The IRS assessed deficiencies on both estates of over $200 million.
The Tax Court reviewed the circumstances and determined that there was a
"bona fide" sale upon the funding of Black LP in 1993. The
uncertainty regarding the family circumstances and the operation of Black
LP as an operating entity for seven years showed that there was a
"legitimate and significant nontax purpose" for the partnership.
In addition to the demonstration that there was a legitimate purpose in
maintaining the ownership of the Erie stock, the Court noted that Mr. and
Mrs. Black had retained approximately $4 million of assets outside the
trust, with an average income of over $600,000 each year. Therefore, they
did not require any trust principal for personal living expenses.
The marital trust was to have been funded from the estate of Mr. Black.
Because this normally would have occurred in due course after the death of
Mr. Black, the valuation of the trust was determined as of date of death of
Mrs. Black. With respect to the loan of $71 million from the Black LP to
the estate for payment of estate taxes on the death of Mrs. Black, the
Court determined that this was completely within the control of the son,
who was executor of the estate and also controlled Black LP. Therefore, the
loan interest was deemed not "necessary" and not deductible.
Finally, the expenses of the secondary offering were partially for the
purpose of benefiting the estate, but also left residual benefits for Black
LP. Therefore, half of those expenses were deductible for the estate.
Applicable Federal Rate of 3.2% for December -- Rev. Rul. 2009-38;
2009-49 IRB 1 (17 Nov. 2009)
The IRS has announced the Applicable Federal Rate (AFR) for December of
2009. The AFR under Sec. 7520 for the month of December will be 3.2%. The
rates for November of 3.2% or October of 3.2% also may be used. The highest
AFR is beneficial for charitable deductions of remainder interests. The
lowest AFR is best for lead trusts and life estate reserved agreements.
With a gift annuity, if the annuitant desires greater tax-free payments the
lowest AFR is preferable. During 2009, pooled income funds in existence
less than three tax years must use a 4.8% deemed rate of return. Federal
rates are available by clicking
here.
A created a CRAT (Trust) that paid income to A for A's life
and then to A's son, B. Trustee is also the irrevocable charitable
remainder beneficiary of Trust. A died on Date and left B as the current
income beneficiary. Trustee, with B's permission, sought to modify Trust to
permit it to make current distributions to Trustee in order to support
Trustee's scholarship program. The distributions will be made only if Trust
earns over X amount annually. In the event that Trust earns Y amount over
X, an additional distribution may be made to Trustee. If Trust earns less
than X, no distribution will be made to Trustee in that year. A court
having jurisdiction approved the modification subject to Trust receiving a
favorable Letter Ruling from the IRS.
The Service noted that Under Sec. 664 and the accompanying regulations, no
distribution may be made from a CRT other than to the named income
beneficiaries living at the time of the trust's creation and the named
charitable remainder beneficiary. Because Trust would make its fixed
payments to B, the occasional distributions to Trustee will not violate
Sec. 664. Therefore, the modification was permitted.
Editor's Note: The Service indicated that the distributions to the
charitable beneficiary are considered to be made from the "corpus and
of those categories of income... in an order inverse to that described in
Sec. 1.664-1(d)(1)." In other words, the distributions made to charity
will be made under a system of reverse four-tier accounting or best-in,
first-out. This provision allows the distribution but insures that the
non-charitable income beneficiary is not able to avoid the ordinary or
capital gains taxes on his/her distribution from the CRAT.
Depression Babies Seek Security – Baby Boomers Move to
Retirement
With the massive changes in our financial system the past two years, baby
boomers and the depression babies are asking, "What is likely to occur
in the future?" While predictions are indeed difficult, by examining
the past and the present it is possible to make several projections about
the future. Part I of this article discussed the economy and wealth, the
impending tax increases on the affluent and the probable boom in financial
counseling. Part II will analyze charitable financial planning options for
the depression babies group and the baby boomers.
The sections for each will include a prediction, an analysis of the factors
surrounding that prediction, and an explanation of the likely impact on
major and planned gift donors.
Lucky Lucy Lindstrom finished college and headed west. She
started as a financial analyst with a large company in Seattle. After just
four years, she became a Registered Investment Advisor (RIA) and began
advising clients. Lucky Lucy also managed her own investments. With her
keen insight into financial markets, Lucy soon began to move from
traditional stocks and bonds into futures and commodities. Lucky Lucy was
so successful in these markets that she now manages only her mega-dollar
personal portfolio.
Somewhat late in life, Lucky Lucy discovered the wonderful world of
philanthropy. She volunteered at her favorite charity, and learned that
giving someone in need a helping hand is even more gratifying than making
another million in the futures market.
Lucy had invested $1,000,000 in stock in a Canadian oil
"wildcatter" with the name Northern Long Shot, Inc. This company
has been drilling new exploratory wells in the far north. Recently, the
stock rose from the $1 per share that she paid to over $5 per share. After
this success, Northern Long Shot decided to "spin off" a smaller
company with a portion of the successful wells. Lucy exchanged her $5
million in stock for 60% of the stock in Northern Long Shot, Inc. After the
exchange, Lucy decided to give the Northern Long Shot stock to a private
charitable foundation to help those in need.
Lucy discussed options with her attorney. She also asked her attorney
whether Northern Long Shot Foundation would pay any tax. Her attorney noted
that private foundations are subject to various rules on self-dealing,
minimum distributions and excess business holdings, and taxable
distributions. In addition, a private foundation pays an excise tax on
income. Lucy exclaimed, "What! Pay tax? This is a charitable
foundation! Why should a charitable foundation have to pay tax? And how
much tax will be paid?"
Note: Case studies, articles, commentary and other materials in the
GiftLaw system are included solely as educational information. Articles and
editorial comments are offered as an educational service to friends of this
organization, and may not always reflect our official position on any
issue. Since case studies or articles may not always reflect the current
AFR or tax law, it may be necessary to run any illustration with a current
version of Crescendo to obtain updated information. If professional
services are required, all persons shall consult with their qualified
professional advisors. Tax Quotes are courtesy of Jeffery L. Yablon,
Washington, D.C.
©
Copyright 1999-2009 Crescendo Interactive, Inc.
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