WHAT’S NEW AND WHAT’S
LEFT IN SOPHISTICATED ESTATE PLANNING
By James H. Beauchamp 2005
A.
Lifetime Gifts (Non-Charitable) in General
When Congress passed the Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”), many changes were made to the Gift and Estate Tax statutes, the most significant of which was the repeal of estate taxes for persons dying in the year of 2010. If a wealthy person dies in 2011, however, estate taxes must again be considered. The “Sunset Rule” is the culprit in the legislation, and before we consider other topics, we must first understand what the Sunset Rule is. Under a procedure enacted in 1974, rules were established which dealt with Congressional Budgets. One of the rules, known as the Byrd Rule (Senator Byrd from West Virginia), made part of the Budget Act of 1990, permits any member of Congress to raise a point of order against extraneous provisions being included in a budget reconciliation bill. If reducing taxes might increase the deficit for a fiscal year beyond the years covered by the reconciliation matter, the law requires 60 Senators to vote in favor of the tax legislation. Failing to attain such a vote means the tax legislation can last no longer than 10 years.
Less than 60 Senators voted in favor of EGTRRA, so EGTTRA
will expire on December 31, 2010 (unless Congress changes the law again). So in considering gift and estate taxes, we
must remember that the rules have changed, but not forever.
Basic Math: Estate Taxes. With this introduction, let’s begin with an explanation of how estate and gift taxes are computed To compute Federal Estate Taxes, the taxable estate is computed using the tax table reproduced below1. Excluded from the taxable estate is property interests passing to a surviving spouse which qualify for the marital deduction.
Let’s take an example. Suppose Uncle Fred died in 2005, and left
his nephew as his sole heir, and that Uncle Fred’s taxable estate was
$1,500,000. Using the tax table below, one
can determine the tax to be $555,800.
Let’s also assume Uncle Fred’s estate is entitled to take the entire
estate tax credit of $555,800. Based on
these assumptions, the net tax due to the IRS is zero. Had Uncle Fred’s taxable estate been
$2,000,000, the tax would be $780,800, the credit $555,800, and his estate
would owe the difference between the two, or, $225,000 ($780,800 less
$555,800). IRC §2001
EGTRRA increases the amount of the estate tax credit over
time. Using the same example, if Uncle
Fred died in 2006 with a taxable estate of $2,000,000, the tax is $780,800, but
the estate tax credit increases to $780,800.
Thus, the nephew will inherit $2,000,000 without paying any estate
taxes. Here is the new estate tax
credit table applicable to decedents (the gift tax side of the equation is
dealt with later in the outline):
Year Tax
Rate Estate
(and GST) Exemption Estate
Credit
2004 48% 1,500,000. $555,800
2005 47% 1,500,000. $555,800
2006 46% 2,000,000. $780,800
2007 45% 2,000,000. $780,800
2008 45% 2,000,000. $780,800
2009 45% 3,500,000. $1,455,800
2010 0%
2011
55%
$1,000,000. $345,000.
Here are the tax tables
themselves:
|
|
|
Gift
and Estate Tax Rates 2005 (top rate in 2005 is 47%) |
||
|
|
|
|
|
Of The |
|
|
|
|
% on |
Amount |
|
Over |
Not Over |
Pay+ |
Excess |
Over |
|
|
|
|
|
|
|
0 |
10,000 |
0 |
18 |
0 |
|
10,000 |
20,000 |
1,800 |
20 |
10,000 |
|
20,000 |
40,000 |
3,800 |
22 |
20,000 |
|
40,000 |
60,000 |
8,200 |
24 |
40,000 |
|
60,000 |
80,000 |
13,000 |
26 |
60,000 |
|
80,000 |
100,000 |
18,200 |
28 |
80,000 |
|
100,000 |
150,000 |
23,800 |
30 |
100,000 |
|
150,000 |
250,000 |
38,800 |
32 |
150,000 |
|
250,000 |
500,000 |
70,800 |
34 |
250,000 |
|
500,000 |
750,000 |
155,800 |
37 |
500,000 |
|
750,000 |
1,000,000 |
248,300 |
39 |
750,000 |
|
1,000,000 |
1,250,000 |
345,800 |
41 |
1,000,000 |
|
1,250,000 |
1,500,000 |
448,300 |
43 |
1,250,000 |
|
1,500,000 |
2,000,000 |
555,800 |
45 |
1,500,000 |
|
2,000,000 |
|
780,800 |
47 |
2,000,000 |
|
|
|
|
|
|
When Congress passed EGTRRA,
the concept of the “unified credit” was modified. A credit against gift and estate taxes is available, but since
Congress did not repeal the gift taxes, changes were made relating to the
credit available for gifts.
Basic Concepts: Inter vivos
Gifts. For
tax purposes, there are only two means of making lifetime transfers: gifts and
sales. Although these categories seem
airtight, as with most things in life, these classifications are not always
treated as they seem. So let’s begin
with a refresher course on gifts, then we’ll turn to sales.
Gifts
There are three elements to a gift, which are, a donor
intends to make a gift, he completes the gift by delivery to or for the donee,
and the donee accepts the gift. All
three elements are required in order to effectuate a completed gift (incomplete
gifts are not gifts).
Basic Concepts: Gift taxes. Once a gift has been completed, one must
consider the tax ramifications. In
Oklahoma, there are no gift taxes.
However, there are gift taxes at the federal level, and have been since
the Revenue Act of 1924. Although gift
taxes have been repealed and reenacted over the course of time, the federal
government imposes the tax as an excise tax upon the privilege of making a
transfer by gift. This tax applies to
transfers made in trust or otherwise, and to transfers, direct or indirect, of
property, be it real or personal, tangible or intangible (IRC § 2511).
For tax purposes, only completed gifts are taxed, and
control of the property is a key issue.
If a “gift” is made to a revocable trust, the grantor still has control
of the trust, so the gift is considered as being incomplete, and there are no
gift tax ramifications.
Let us assume a completed gift has been made, and gift
taxes must be paid. The gift tax rates
are the same as shown below; the effective exemption amount is different from
estate taxes, beginning in 2004. After
the repeal of estate taxes in 2010, we still have gift taxes to pay (the rates
will be the highest income tax rate, currently scheduled to be 35%). In the year 2010, the estate tax “step-up”
in basis is repealed, which means, the heirs of an estate will have the same
tax basis as the decedent (for capital gains purposes). There are two exceptions – spouses leaving
property to widows or widowers are entitled for a step-up in basis, up to $4.3
million ($3 million, plus using the other $1.3 million), and if the spouse
doesn’t use the other $1.3 million, then $1.3 in assets transferred to
others. Here are the new gift tax
rates, exemptions and credits:
Year Tax Rate Gift Tax Exemption Gift Credit
2005 47% 1,000,000. $345,000
2006 46% 1,000,000. $345,000
2007 45% 1,000,000. $345,000
2008 45% 1,000,000. $345,000
2009 45% 1,000,000. $345,000
2010 35% 1,000,000 $345,000
2011 55% $1,000,000. $345,000
In addition to the lifetime gift tax exemptions, donors may deduct the
annual exclusion. The gift tax annual
exclusion – $11,000 per donee, for the year 2005 – is not allowed for gifts of
future interests in property. A future
interest is an interest in property, where the right to use, possess, or enjoy
the property is postponed until a future date. Although a future interest may
vest immediately in the donee, it will be deemed a future interest for gift tax
purposes, if the donee cannot enjoy or use it presently. IRC § 2503(b)(1); Reg
§ 25.2503-2. Future interests include reversions, remainders, and other
interests or estates, whether vested or contingent, which do not commence in
use, possession, or enjoyment until some future time. Future interests must be
reported at their full value for gift tax purposes, but the annual exclusion
may not be used.
Sales
The only other means of effecting of a conveyance, if it is not a gift,
is by a sale. The difficulty with a
sale is the seller will be subject to capital gains taxes, and may be subject
to recapture of depreciation taken on the property (which is treated as
ordinary income). If the sale is made
for inadequate consideration, the IRS might contend that it is a gift.
As a freshman in law school, I was taught that property had many attributes,
and that each attribute should be considered as a stick – and that the
characteristics of property could be analyzed as if property were simply a
bundle of sticks. With that analogy fixed in my mind, the professor then began
delineating different types of conveyances, each having different
characteristics.
We will use that analogy at
this point in the outline, because we are going to consider conveyances of
property which are not absolute conveyances; specifically, we will discuss life
estates, term of years, GRITS, QPRTs, GRATS and GRUTS. In each instance, the conveyance made by the
grantor splits the ownership interests into something less than what the
grantor originally owned.
A life estate is created by a conveyance, typically a deed, in which
the grantee is given an interest in property for the term of the grantee’s
life; when the grantee dies, the remainder interest, which is a vested
interest, is no longer subject to the life estate. A variation of a life estate may be accomplished in a trust: the trustee is directed to retain title to
the property for the life of a person, and upon that person’s death, to convey
the remainder interest to another person (or persons).
What are the attributes of
ownership, in a life estate? Until the
death of the life tenant, the life tenant owns the property to the exclusion of
anyone else. Take this example. The grantor conveys the real estate to himself,
for his life or some other life. The
life tenant has possession or enjoyment, or the right to income, during his
lifetime. Upon the death of the life
tenant, title to the property then belongs to whomever is named as the
remainderman. If this type of
conveyance is made by deed (not by a trust instrument), the life tenant can
sell his or her interest to someone else.
The buyer in such a case will enjoy the property so long as the seller
is alive. When the seller (the life
tenant) dies, the buyer’s interest in the property ends.
Now let’s explore a technique using life estates. During
the past few years, many children are concerned about whether they will receive
an inheritance when their parents die. Their primary fear is that the
inheritance will be lost if the parent is placed in a nursing home, when DHS
pays for nursing home bills. When the
parent dies, DHS will demand reimbursement from the estate of the decedent,
dollar for dollar, for all expenses paid for by DHS.
One technique that has been used, with limited success,
is the creation of a life estate in the parent, with a remainder interest in
the children. Using actuarial tables,
it is possible to compute the value of the life estate. Suppose a 70 year old parent who is in a
nursing home conveys his $100,000 home to himself in November of 2004 (assume
an applicable Section 7520 rate of 4.2%), for life, and on his death, the
remainder goes to his son. The value of
his life estate can be computed, and for your information, is worth
$40,758.
If the donor is in the
nursing home, and owns a life estate in real estate worth $40,758, DHS will not
pay for nursing home benefits, to the extent of the value of the life estate –
so if a nursing home charges $3,000 a month, DHS will not pay for benefits for
14 months ($3,000 x 14 = $42,000).
After the parent pays the bill for 14 months in a nursing home, it would
appear that DHS would begin to pay for nursing home benefits in the 15th
month, if we assume the parent had less than $2,000 in cash assets at that
time. When the parent dies, there is no
probate of the remainder interest, since it is a vested interest in the
son. Under this scenario, however, the
question must be asked, who will live in the home and take care of it while the
parent is in the nursing home? If the
home is rented, then the rental income might disqualify the parent from DHS
assistance, if the parent’s income is too much (i.e., more than DHS permits).
Let’s not forget gift taxes: if the life estate is worth
$40,758, then the remainder interest is worth $59,242 ($100,000 less
$40,758). This gift is a future
interest, and will not qualify for any annual exclusion. Presumably, the parent will use part of the
lifetime gift tax credit, so the parent will not have to pay the gift tax
(which would be $12,818).
Nor should we overlook federal estate taxes: under
Section 2036 of the Internal Revenue Code, all property transferred by a
decedent, in which he retained an interest for life, is included in his gross
estate. Thus, there are no particular
estate tax benefits in creating a life estate.
Transfers which are to take effect only at death are
included in the grantor’s taxable estate, under IRC Section 2037, if the
decedent retains a reversionary interest worth 5% or more of the value of the
property. In addition, transfers made for
insufficient consideration are taxable and are included in the estate under
Section 2043, and as well as revocable transfers, which are included under
Section 2038.
Term of Years
Although term of years conveyances are not the sorts of things people
think of, when they are planning their estates, the concept is very similar to
a lease of real estate – however, the owner for the term of years actually owns
the property during that time. The
primary application I’ve used in creating a term of years is in a pre-nuptial
agreement, where the prospective husband will grant the prospective wife a term
of years (not to exceed her life-time), for his home (where they both will
live). The normal provision in the
ante-nuptial agreement is that if the husband dies, and the wife then remarries
or co-habits with another person of the opposite sex, the term of years will
terminate and the property will then belong to the remaindermen.
The other applications for terms of years are things that
were once very popular, but have now slipped into some disfavor, viz., grantor
retained annuity trusts, grantor retained income trusts, and grantor retained
unitrusts. In these trusts, the grantor
retains an interest in irrevocably transferred property. The remainder interest passes to the
designated beneficiaries at the end of a specified term, or the grantor’s
death. Each of these types of
conveyances deserves a bit more explanation.
GRITS. A Grantor Retained Income
Trust (GRIT) or a Qualified Personal Residence Trust (QPRT), is an irrevocable
trust, where the grantor retains an income interest in property for a term of
years. After the term of years, the
trustee conveys the remainder interest to named beneficiaries. Although there is a “future interest”
involved, viz., the portion which will be conveyed to the remainder
beneficiaries, we must nonetheless consider the gift tax aspects of a GRIT.
Stated
differently, when the trust is funded, a future gift is made. The value of the gift is the excess of the
FMV of the transferred property, less the value of the term of years (i.e.,
that which is retained by the grantor).
To make such a computation, we simply multiply the fair market value of
an annuity factor times the term of years.
Assume a 7.6 discount rate (i.e., the §7520 rate), and a
term of years of 10 years. Also assume
the grantor places property having an initial value of $100,000 into the
trust. If the grantor is 65 year old,
his interest is worth $63,458. Subtract
this amount from $100,000, to determine the portion of the gift subject to gift
tax: $36,542. Because this gift is a future interest, it will not qualify for
the annual exclusion. The grantor will
have to use all or part of his remaining gift tax credit, or pay gift tax. If the grantor is a bit younger, then the
value of the grantor’s retained interest might actuarially be 100%. This would eliminate any gift tax liability.
The advantage of a GRIT is that an individual can
transfer a significant value property to others, but pay little or no gift
tax.
A GRIT is, of course, subject to the grantor trust rules,
which means that all income, deductions and credits are treated as if there is
no trust and these items are attributable directly to the grantor.
Should the Grantor die during the term of years, the entire
trust principal will be included in the Grantor’s estate, because he owns an
interest which does not end before his death.
If gift tax were paid at the outset, then the total estate taxes would
be reduced. If the gift tax credit were
used at the outset, to “pay for the gift tax”, then upon the death of the
Grantor, the portion used would be restored to the estate. As a means of
purchasing discount dollars to pay for estate taxes, a remainderman beneficiary
might purchase life insurance on the life of the grantor, for a term of years.
Under Chapter 14 (special
valuation rules), the Internal Revenue Code (§2702) limits the benefits of
GRITs, where family members are remainder beneficiaries. The Treasury tables
ordinarily used to value trust interests are disregarded, and retained
interests are valued at zero. Thus, a grantor will have 100% gift tax
liability, if, after the term of years, the trust corpus is transferred to
family members. A "member of the family" means (1) the individual's
spouse, (2) any ancestor or lineal descendant of the individual or the
individual's spouse, (3) any brother or sister of the individual, and (4) any
spouse of any individual described in (2) or (3). Family members do not include nieces and nephews.
One exception to the Chapter
14 rules is an incomplete gift. If the
gift is incomplete, then the property is included in the donor’s estate. Another exception to the Chapter 14 rules
might be the Grantor’s home. A Qualified Personal Residence Trust, or QPRT
(sometimes called a 'residence or house GRIT'), is a safe harbor from the
Chapter 14 rules. Suppose a grantor creates a QPRT by transferring his personal
residence to a trust and retains the right to use the residence without the
payment of rent for a specified period of time. At the end of that period, the
residence either passes outright to beneficiaries designated by the grantor
(usually members of his family) or the trust is continued for their benefit. If
the grantor continues to occupy the residence after his retained interest
terminates, he must pay fair market value rent to the remaindermen.
When the grantor transfers
his residence to the trust, he is treated as having made a gift to the family
members who will receive the residence when his retained interest terminates.
The value of the gift is the fair market value of the residence, reduced by the
present value of the grantor's retained interest (the right to live in the
residence rent free for the specified period of time). The present value of the
retained interest is computed under IRC §7520, which calls for the use of IRS
valuation tables and the §7520 interest rate for the month of the transfer. The
value of the retained interest is usually more than the rental value of the
residence based on market conditions, which, if combined with a nominal growth
in the FMV of the residence, results in an a good discount for gift tax
purposes.
When the grantor's retained
interest terminates, the residence passes to the remaindermen free of
additional gift tax, even though the property may have appreciated in value
since the trust was created. Thus, use of a QPRT 'freezes' the value of the
residence at its market value when the trust is created. If the real estate
market is low when the trust is created, the discount in gifting will be even
greater.
If the grantor is still
living when his retained interest terminates, the residence won't be includible
in his gross estate for estate tax purposes (unless he continues to live in the
residence without paying fair market value rent, in which case it will be
includible under the retained life estate rule of §2036(a)). If the grantor
dies during the term of his retained interest, the residence will be includible
in his gross estate under the retained life estate rule. But he won't be any
worse off than he would have been if he hadn't created the trust in the first
place.
There are some drawbacks to
QPRTs:
Loss of ownership during the grantor's life.
No step-up in basis. When the residence passes to the remaindermen
at the end of the trust term, they don't get a stepped-up basis. Instead,
the grantor's basis carries over to them, so if they sell the residence
they will have to pay capital gains tax on any gains made over what the
grantor originally paid for the property (plus or minus adjustments to
basis). This problem can't be avoided by having the grantor buy back the
residence from the trust before the trust term ends, because the governing
instrument of a QPRT must include a provision prohibiting the sale of the
residence to the grantor, the grantor's spouse, or an entity controlled by
either of them.
Loss of property tax exemption. The transfer of the residence to a
QPRT results in the loss of a homestead property tax exemption in
Oklahoma.
Inability to mortgage the residence after the QPRT is created. If
the grantor needs to raise cash for any reason after creating a QPRT, he
can't do so by mortgaging the residence, because he's no longer the owner
of the residence.
How do we
compute values for QPRTs? The easiest
method is to purchase a computer program, such as Number Cruncher
(www.leimberg.com). If you believe in
doing your own math, here’s how it works:
SMART MAN, age
55, transfers his personal residence to a QPRT and retains the right to live in
the residence rent-free for 15 years. If Smart Man dies before the end of the
15 years, the trust property is counted as part of his taxable estate. The fair
market value of the residence at the time the trust is funded is $2,000,000.
Assume a §7520 interest rate of 6.4%. The value of Smart Man's retained
interest is $1,372,298, computed as follows:
(1) Find the required life
expectancy
factors from
Table
90CM.
Initial
age = 55
Term of
years = 15
Terminal age = 70
1 minus - value, Table 90CM, age 55 = 89658
1 minus value, Table 90CM, age 70 = 71357
(2) Divide the factor for age 70
(71357) by
the factor for age 55
(89658).
71357 /
89658 = .79588
(3) Take the §7520
rate for
the month the trust is
created
(6.4%, or .064), and add it
to the
number 1.
1 +
.064 = 1.064
(4) Take the figure computed in step
(3)
(1.064) and calculate it to
the 15th
power (because the term
of the
trust is 15 years; if the term
of the
trust were 10 years, you
would
calculate 1.064 to the 10th
power).
1.06415 = 2.535855
(the calculator that comes with Windows operating
system is shifted to the scientific view; enter 1.064, then X^Y, then 15, then
=; X^Y function is the same as X to the Y power)
(5) Divide the result in step (2)
(.79588)
by the result in step
(4) (2.535855).
.79588 / 2.535855
= .313851
(6) Subtract the result in step (5)
(.313851)
from the number 1.
1 -
.313851 = .686149
(7) Multiply the result in step (6)
(.686149)
by the fair market
value of
the residence
($2,000,000).
.686149 X $2,000,000 =
$1,372,298
Thus, the term of years
value of Smart Man's retained interest in his home is $1,372,298. The value of
the remainder interest is the difference between the FMV and the retained
interest, i.e., $627,702 ($2,000,000 - $1,372,298). Thus, the amount of the
taxable gift made by Smart Man on the transfer of the residence to the trust is
$627,702.
In this example, Smart Man
retained a contingent principal interest (the right to have the trust property
distributed to his estate if he dies before the end of the 15 years). If he did not retain such an interest, the
value of his retained interest would be $1,211,312. That amount is determined
by multiplying the fair market value of the residence ($2,000,000) by .605656
(the factor from Table B of the IRS valuation tables for valuing an income
interest payable for a term certain of 15 years, using a §7520 interest rate of 6.4%). The value of the
taxable gift made by Smart Man on the transfer of the residence to the trust
would therefore have been $788,688 ($2,000,000 - $1,211,312).
Thus, by not retaining a
contingent principal interest in the trust, Smart Man can reduce the amount of
his taxable gift by $160,986 ($788,688 - $627,702).
IRS regulations permit a
QPRT to be converted to an annuity trust if the trust is not a qualified
personal residence trust (for example, if the personal residence were
sold). So, with that pitiful segue into
annuity trusts, we will now turn to the topic of GRATs and GRUTs.
GRATS and GRUTs. A grantor retained annuity trust (GRAT) is another
irrevocable trust – the grantor retains a fixed annuity interest in the
property transferred to the trust, for a term of years or for life (e.g., if
the corpus is $100,000, and the annuity amount is 5%, the grantor will be paid
$5,000 per year; this is the interest the grantor retains for the term of years
or for his life). The remainder
interest generally passes to the grantor’s designated beneficiaries at the end
of the term of years, or at the grantor’s death. There is a gift tax due on the value of the remainder interest,
which is dealt with when the trust is created and funded.
A grantor retained unitrust
(GRUT) is also an irrevocable trust – the grantor retains a fixed interest in
the property transferred to the trust, for a term of years or for life, but the
fair market value of the trust corpus at the beginning of each year is used to
determine the amount paid to the grantor (e.g., if the trust property is worth
$100,000, and the payout is 5%, the grantor receives $5,000; if the corpus
increases to $200,000, the grantor will receive $10,000 for that year). When
the grantor's retained interest terminates, the trust corpus passes to the
remaindermen free of additional gift tax, even if it has appreciated in value.
If the grantor is still living when his retained interest terminates, the trust
corpus is not includible in his estate for estate tax purposes when he dies
because he no longer has any interest in the property. If the grantor dies
during the term of his retained interest, part or all of the trust property
will be includible in his gross estate. But again, he won't be any worse off
than he would have been if he hadn't created the trust in the first place.
Suppose a wealthy client
owns high yielding and rapidly appreciating property, but wants to avoid
probate, and is willing to relinquish his interest in the property in the
future, as a means of avoiding estate taxes.
GRATs might provide a solution.
Gift taxes are determined when the trust is created and funded, using
methods similar to computing taxes for GRITs.
The annuity interest (and in some cases, other retained interests) is
subtracted from the fair market value of the assets transferred in trust. The value of the annuity interest depends on
who the remainder beneficiaries are and who retains the annuity, and other
interests relative to the transfer.
There are more restrictive and less appealing sets of valuation rules when
a family member is a beneficiary.
In order to create a GRAT or
a GRIT, you must either own Number Cruncher or other program, or be familiar
with the IRS valuation tables. The Tax
Court determined that the retained interest is valued for the fixed term of the
trust (Walton, Audrey J., (2000) 115 TC No. 41), and the IRS announced
that it will follow the Tax Court’s holding (Notice 2003-72, 44 IRB 964). Walton stands for the proposition
that a GRAT can be created for a term of years with the condition that if the
grantor dies during the term, the annuity will continue to be paid to his
estate. If that is the case, then the
GRAT could hypothetically have a remainder value of 0 or close to 0. The trust corpus would, in effect, pass to
the remaindermen with no gift or estate taxes.
To give you an
idea of the complexity of making these computations, let’s use this example:
SMART WOMAN, age 65, creates a GRAT for a term of ten years and funds the trust
with property valued at $1,000,000. SMART WOMAN retains the right to receive
$100,000 from the trust each year, with annual payments to be made to her at
the end of the year. At the end of 10 years, the property will be transferred
to her children. The §7520 rate for the
month in which the trust is created is 7.2%. The present value of the remainder
interest (i.e., the gift to the remaindermen) is $370,298, determined as
follows:
(1) Determine the required annuity factor as follows:
Initial
age = 65
Term of
years = 10
Terminal
age = 75
N-factor,
Table H (7.2), age 65 = 7671.994
N-factor,
Table H (7.2), age 75 = 2215.108
Difference 5456.886
D-factor,
Table H (7.2), age 65 = 866.5824
Required
annuity factor
=
5456.886 / 866.5824 = 6.29702
(2) Annuity amount $100,000
(3) Present value of annuity
interest
((1) X (2))
$629,702
(4) Value of property
transferred to trust $1,000,000
(5) Present value of
remainder
interest
((4) minus
(3)) $370,298
In this example, gift taxes
will be paid on property worth $370,298.
If the trust corpus produces over 10% a year, SMART WOMAN will have
transferred $1,000,000 worth of property to her kids but she has only paid gift
taxes on $370,298. Note: the Chapter 14 rules apply (in part). Had
the parties been unrelated, then IRC §2702 doesn’t apply, and interests are
valued according to their actuarial present value using the valuation rules of
IRC §7520. These rules mandate using a
discount rate of 120% of the applicable federal annual midterm rate for the
month in which the trust is created and funded. In this instance, the taxable gift would be $304,090.
Let me make a parenthetical comment on interest rates.
The 120% applicable federal annual midterm rate and the §7520 rate change
monthly and are reported in the IRS cumulative bulletin and various tax
services, and in various financial publications, such as the Wall Street
Journal. This rate can also be obtained
by visiting www.brentmark.com or www.leimberg.com.
Suppose the income earned on
the trust corpus is less than the annuity amount; in that case, the shortfall
is made up from the principal. All
income and appreciation in excess of that required to pay the annuity
accumulates for the benefit of the remainder beneficiary. Therefore, it is possible to transfer assets
to the beneficiary when the trust terminates with values which far exceed their
original values. Such a transfer is not
subject to further gift tax.
Under the Chapter 14 rules,
where intra-family transfers of interests are made in trust, and the transferor
retains an interest in the GRUT, the value of a qualified unitrust interest is
determined as if it were an interest in a charitable remainder unitrust. I will
not attempt to illustrate computations dealing with a GRUT, but will opine that
they are more complicated that GRATs.
Using factors similar to those of SMART WOMAN, gift taxes would be paid
of approximately $643,000 (where the remainder interest goes to a family
member) or approximately $604,000 (where the remainder interest goes to a
non-family member).
There are many more options
available in creating a GRUT, such as, permitting the trust assets to revert to
the grantor’s estate, in the event of the grantor’s premature death. In addition, the annuity amount can be
increased, but not by more than 120% of the prior year’s payout rate. For example, the trust could provide the
annuity payout rate in each subsequent year equal 120% of the prior year’s
rate. If the initial annuity payout
rate is 5%, it could increase to 6% in the second year, to 7.2% in the third
year, and so on.
One final thought: GRATs and
GRITs are subject to the grantor trust rules, which means, there are income tax
consequences to the grantor, regardless of what amount is paid to the grantor
by the GRAT or GRIT. The grantor will be taxed on income and on realized gains
from the sale of assets, even if the income and gains are more than the
required trust payments.
With the repeal of Estate Taxes in
2010, and the possibility of a permanent repeal of Estate taxes, it appears we
might still be faced with additional income taxes, which will require us to
keep more sets of records. And our
heirs will have “one more tax” to pay, which will be in the nature of additional
income taxes. Since brevity is the
essence of clarity, let me cut to the chase: charitable remainder trusts may be
of more value if the estate taxes are permanently repealed.
As
things now stand, when a person dies, the heirs inherit the property at the
fair market value at the date of death – thus, the heirs will have a new tax
“cost” basis, and there are no additional estate taxes on the “step-up” in
basis. If the estate taxes are
permanently repealed after year 2010, Congress may eliminate the benefit of the
set-up in basis (under current legislation, there is a partial step-up in
basis, for those dying in 2010: $1.3
million for every person, and $3.0 million for property left to the
spouse). Assume, for purposes of this
section of the outline, that my heirs acquire my estate, without an estate tax,
but that my estate is not eligible for a step-up in basis. My heirs’ cost basis will be the same as
mine, for income and capital gains purposes.
If I paid $70,000 for commercial real estate in 1985, and depreciated it
as a business property, my heirs inherit my cost basis: after I die, and assuming the estate taxes
are repealed, there will be no estate tax to be paid. However, when the commercial real estate is sold by my children,
they will have two income taxes to pay:
(a)
Capital gains tax based on the difference between their sales price (let’s say
$150,000) and my purchase price ($70,000).
If long term capital gains rates remain at 15%, plus 7% for Oklahoma,
then that part of the tax bill will be $17,600 ($150,000 - $70,000 = $80,000 x
22% = $17,600).
(b) In addition, they will be taxed at ordinary
income tax rates, for all of the depreciation I have taken on the property
(e.g., $50,000) – this tax is called “recapture of depreciation”. If my children are in the 25% income tax
bracket, this tax will be $12,500 ($50,000 x 25% = $12,500).
Thus,
the total income tax to be paid when the commercial real estate is sold by
children is $30,100 ($17,600 + $12,500 = $30,100).
So
how might we plan around this scenario?
I might create a Charitable Remainder Trust (Reg. §1.664-1), to
eliminate the income taxes for me and my heirs. First, I would locate and retain a sharp accountant and lawyer to
help create the trust; I would probably ask them to modify one of the forms the
Treasury Department has promulgated (that ought to save some legal and
accounting fees; sample forms may be found at Rev. Proc 90-30 and
2003-53). The agreement would provide
that during my lifetime, and during the lifetime of my spouse, the trustee
would pay me 5% of the fair market value of property every year (I will have to
pay income taxes on this annual payment).
Secondly, I will have the property appraised, on an annual basis (this
requirement is part of the agreement, which is a Charitable Remainder Unitrust,
as opposed to a Charitable Remainder Annuity Trust). Third, I will be able to take an income tax deduction for
donating the property to charity, based on some very complicated calculations
(the amount of the deduction depends on the value of the property, the life
expectancies of me and my wife, using a variable rate of interest established
by the Treasury Department). And
finally, I will have to find a good charity, which will own the trust property
after my wife and I die.
Once
the trust has been established, the trustee can then sell the commercial real
estate, and pay no income tax (the CRT is, in effect, treated as a private
foundation, but the CRT is not required to request tax exempt status, by filing
a Form 1023). Thus, there are no
capital gains taxes to pay, nor are there any ordinary income taxes to pay for
recapture of depreciation. The proceeds
from the sale will be retained until both my wife and I are deceased.
When
both my wife and I are deceased, the charity named in the trust will inherit
whatever is left in the trust corpus.
As a technical note, the charity is required to receive at least 10% of
the value of the CRT, and this qualifying determination will be made before the
trust is established. In addition, the
amount paid to the grantor cannot be less than 5% nor more than 50% of the
trust corpus.
All
of this sounds good, but notice what has happened: I no longer own the commercial real estate – after the trust has
been created, all my wife and I own is the right to receive income while we are
alive. Once we are deceased, the
charity inherits the trust corpus. So
my children will not inherit the $150,000 commercial real estate. To replace this “lost wealth”, I will
probably arrange for the purchase of a life insurance policy for $150,000
(perhaps a second to die policy), and arrange for the policy to be owned by an
irrevocable life insurance trust, or by my children directly. If the estate taxes are permanently
repealed, then I might decide to own the policy myself (as things now stand, if
I have any incidents of ownership over the policy, it is counted as part of my
taxable estate, for estate tax purposes – to keep the policy out my taxable
estate, it must be owned by someone else, viz., my children or the trustee of
an ILIT).
So
what have we done with this process?
First, we have eliminated any income taxes on the sale of the commercial
real estate. Second, we have provided
an income stream (which is taxable as income) for me and my wife. Third, my wife and I will be able to deduct
part of the gift’s value, as a charitable donation. Fourth, the charity will receive an inheritance when my wife and
I die. And fifth, my children will
inherit (without income or estate taxes) the face value of a life insurance
policy.
With
these benefits, there are also some burdens: I have to purchase a life
insurance policy to replace the wealth I have transferred to the CRT (more
insurance premiums), and I have limited my income from the commercial real
estate to a minimum of 5% per year. I
will have more tax returns to file (the CRT will have to file income tax
returns), and I will have to pay more legal and accounting fees to create the
CRT.
Here are some rules and definitions: A charitable remainder annuity trust is a trust that pays a specified sum, not less than 5% of the initial net fair market value of all property placed in trust, at least annually to its income beneficiary or beneficiaries; at the deat