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Obama Budget Takes Aim At Popular Wealth Transfer Tools
Photo Credit: Forbes Business

Obama Budget Takes Aim At Popular Wealth Transfer Tools

Mar 4 2014, 6:42pm CST | by

When Congress passed the American Taxpayer Relief Act or ATRA at the dawn of 2013, it seemed to end 12 years of uncertainty about how much could pass estate-tax free; what the tax will be on...

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20 weeks ago

Obama Budget Takes Aim At Popular Wealth Transfer Tools

Mar 4 2014, 6:42pm CST | by

When Congress passed the American Taxpayer Relief Act or ATRA at the dawn of 2013, it seemed to end 12 years of uncertainty about how much could pass estate-tax free; what the tax will be on transfers above that amount; and even whether there would be an estate tax at all.

If Pres. Obama has his way, we haven’t seen the end of estate tax reform.

The President’s proposed budget for 2015, issued today, would restore the estate tax rates to those that were in effect in 2009 and severely curtail some popular high-end tools for shifting assets to future generations. The Green Book, as it is called, downloads here as a PDF. His hard line on rates may turn out to be a paper tiger since Obama will leave office nearly a year before they would take effect on Jan. 1, 2018. But other proposals could creep into the tax law and take effect long before then.

Under current law, we can each transfer up to $5.34 million tax-free during life or at death without incurring a tax of up to 40%. That figure is called the basic exclusion amount and is adjusted for inflation. In addition, widows and widowers can add any unused exclusion of the spouse who died most recently to their own. This enables them together to transfer up to $10.68 million tax-free.

Under the President’s plan, in 2018 the tax would revert to the rates that were in effect in 2009. At that point the exemption from the estate and generation-skipping transfer tax would drop to $3.5 million per person. Perhaps more importantly, the tax-free amount for lifetime gifts would decline to $1 million. And the top tax rate would rise to 45% from 40% for transfers during life or death that exceed the limits.

There’s been talk–and some feeble attempts–on an off for at least seven years to restrict what are called leveraging techniques: sophisticated estate planning strategies that pack more into the lifetime exemption amount and minimize the gift tax owed.

Don’t expect thoughtful estate tax reform — we’re talking congressional horsetrading, perhaps done incrementally. (Heads up: watch those transportation funding bills.) Here are the most important provisions at play.

NEW TARGET

Unbridled annual exclusion gifts to trusts. Currently you can give $14,000 in cash or other assets each year to each of as many individuals as you want. Spouses can combine this annual exclusion to give $28,000 to any person tax-free – a process called gift-splitting.

One condition for the annual exclusion is that the gift must be a present interest, meaning something the recipient can use right away, rather than a future one. That’s not a problem but if you make gifts of cash or other assets directly to the recipients. But if you use the annual exclusion to fund trusts, as wealthy people like to do, you must satisfy the present interest requirement another way.

The most common way to do that is to give beneficiaries Crummey powers: the right for a limited time, usually 30 or 60 days, to withdraw from the trust the yearly gift attributable to that beneficiary. Each year, the trustees must send a notice, called a Crummey notice, to the beneficiaries (or the parents, if the beneficiaries are minors) letting them know about their right to withdraw their portion of the annual gift to the trust. The notice is named for the Ninth Circuit decision in Crummey v. Comm’r, 397 F.2d 82 (9th Cir. 1968) which provided a roadmap for this work around to the present interest requirement.

Over the years wealthy donors have used (or by some accounts abused) Crummey powers by creating trusts for multiple beneficiaries and funding them each year with huge tax-free gifts by allocating the annual exclusion amount to each beneficiary. The latest budget would do away with that because, as it explains:

“The IRS’s concern has been that Crummey powers could be given to multiple discretionary beneficiaries, most of whom would never receive a distribution from the trust, and thereby inappropriately exclude from gift tax a large total amount of contributions to the trust. (For example, a power could be given to each beneficiary of a discretionary trust for the grantor’s descendants and friendly accommodation parties in the hope that the accommodation parties will not exercise their Crummey powers.)  The IRS has sought (unsuccessfully) to limit the number of available Crummey powers by requiring each powerholder to have some meaningful vested economic interest in the trust over which the power extends. See Estate of Cristofani v. Comm’r, 97 T.C. 74 (1991); Kohlsaat v. Comm’r, 73 TCM 2732 (1997).

The budget favors eliminating the present interest requirement and way that the Crummey power in creating instead a new category of transfers to entities including trusts that could not total more than $50,000 per year.

OLD TARGETS

The low-risk grantor retained annuity trust or GRAT. This device allows someone to put assets into an irrevocable trust and retain the right to receive distributions back over the trust term. The annuity is equal to the value of what’s been contributed plus interest at a rate set each month by the Treasury called the Section 7520 rate (named after the section of the Internal Revenue Code that applies).

If the value of the trust assets increases by more than the hurdle rate, the GRAT will be economically successful. In that case, the excess appreciation will go to family members (the remainder beneficiaries) or to trusts for their benefit when the GRAT term ends. If the appreciation never occurs, the trust can satisfy its payout obligations by returning more of the assets to the grantor—the person who created the trust./>/>

For the moment, it is possible to form what’s called a zeroed-out GRAT, in which the remainder is theoretically worth nothing so that there is no taxable gift. The President’s proposal would require that the remainder interest have a value greater than zero at the time the interest is created and would prohibit any decrease in the annuity during the GRAT term. “Although a minimum term would not prevent “zeroing-out” the gift tax value of the remainder interest, it would increase the risk that the grantor fails to outlive the GRAT term and the resulting loss of any anticipated transfer tax benefit,” the budget states. It would also require that a GRAT have a minimum term of 10 years, compared with the current two-year minimum. These requirements would apply to only to new GRATS, so existing ones would be grandfathered.

This greatly accentuates what is called the “mortality risk” of a GRAT: If the grantor dies during the trust term, all or part of the trust assets will be included in her estate for estate tax purposes. Rich folks would no longer be able to use short-term GRATs to minimize that risk.

Dynasty trusts. Some states allow trusts to continue in perpetuity (or for a very long time) and pass wealth through multiple generations without incurring estate, gift or generation-skipping transfer taxes. These trusts are allowed to continue in perpetuity only in states that have abolished the rule against perpetuities. These include Alaska, Delaware, South Dakota and Wisconsin. Residents of other states can choose one of these states as the situs, or location, of a trust; in most cases, some connection to the state is needed and certain conditions apply.

The President’s proposal would do away with dynasty trusts, limiting the generation-skipping transfer tax exemption to 90 years.

Grantor trusts. This is not a single variety of trust, but a set of characteristics that can be incorporated into various types of popular trusts. The term refers to the fact that the person who creates the trust, known as the grantor, retains certain rights or powers. As a result, the trust is not treated as a separate entity for income tax purposes and the grantor, rather than the trust or its beneficiaries, must pay tax on trust earnings.

A 2004 Revenue Ruling made it clear that paying the tax is not considered a gift to the trust beneficiaries. Yet this tax, on income that the grantor probably never receives, shrinks his estate. At the same time, assets can appreciate inside the trust without being depleted by ordinary income taxes or capital gains taxes.

Until now, another attractive feature of these irrevocable trusts is that assets placed in the trust are removed from the senior family member’s estate. From an estate and gift tax perspective, the transfer is treated as a completed gift. The value of the assets is frozen at the time of the transfer, so that future appreciation is not subject to estate or gift tax. These hugely popular trusts have been used for a broad range of people, from young entrepreneurs with mushrooming assets to elderly couples with securities portfolios.

The President’s proposal would eliminate this additional feature of these trusts. This is an enormous change that would wreck havoc with an important tax-saving tool. On this subject, the budget cribs verbatim from the 2013 budget: “The lack of coordination between the income and transfer tax rules applicable to a grantor trust creates opportunities to structure transactions between the deemed owner and the trust that can result in the transfer of significant wealth by the deemed owner without transfer tax consequences.”

Going forward, Obama would like these trusts to be taxable as part of the grantor’s estate. And distributions from the trust to beneficiaries during the grantor’s life would be subject to gift tax.

Archive of Forbes Articles By Deborah Jacobs

Deborah L. Jacobs , a lawyer and journalist, is the author of Estate Planning Smarts: A Practical, User-Friendly, Action-Oriented Guide, now available in the third edition.

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