As the US government’s budget concerns deepen and popular debate on how additional revenue should be raised continues, private client practitioners may find that certain favoured tax-saving techniques, which may be too obscure for any political party to support, may be curtailed as soon as year’s end. We may soon look back on 2012 as a golden year for planning for high-net-worth clients.
The most obvious opportunity for gift, estate and generation-skipping transfer tax (collectively, ‘transfer tax’) savings is the USD5.12 million transfer tax exemption for US domiciliaries. This exemption amount is scheduled to revert to USD1 million on 1 January 2013. The majority of people affected by this change are likely to be upper-middle class professionals, who may not realise that the few million dollars of assets they may own on death are enough to subject their estates to tax. Any US domiciliary who is at risk of owning more than USD1 million of assets at death, and who can afford to part with a portion of their wealth today, should consider making gifts to their children and grandchildren while they are able to do so tax-free.
Trusts are the favoured vehicle to receive such gifts. If the client is concerned about losing access to the gifted asset, they may consider adding their spouse as a discretionary trust beneficiary. This requires greater care if each spouse establishes a trust that includes the other spouse as a beneficiary, on account of the reciprocal trust doctrine. This doctrine, in effect, may treat each spouse as establishing a trust for their own benefit – trusts which typically do not escape estate tax.
Those with more assets to shelter should consider using their exemption amount to benefit from greater tax savings. For example, a person with USD100 million in assets may fund a trust for their children with a USD5 million gift and a USD50 million loan that pays interest annually and principal at the end of the ninth year. The Internal Revenue Service (IRS) sanctioned interest rate for family loans of this duration made in March 2012 is 1.08 per cent. This combination gift/loan provides two benefits. First, the USD5 million exemption is effectively captured. Second, the loan of USD50 million is frozen in the client’s estate because gains on this amount, which the trust may derive from stock trading with the borrowed funds, for example, inure to the trust to the extent they exceed 1.08 per cent on average.
‘The key to structuring a combination gift/loan is identifying a reasonable loan-to-value ratio’
The key to structuring the combination gift/loan is identifying a commercially reasonable loan-to-value ratio. Otherwise, the loan may be characterised as a taxable gift. The USD5 million gift and USD50 million loan described results in a loan-to-value ratio of approximately 90 per cent. Risk-averse clients may prefer more conservative ratios, resulting in smaller loans, though the IRS tends to focus primarily on the trust’s ability to repay loans. In any event, because the exemption is currently USD5.12 million, a combination gift/loan made in 2012 can freeze a significant portion of a client’s estate.
The scheduled reduction in the transfer tax exemption amount may not be the only impending change to make combined gift/loan planning more appealing this year. The US Treasury Department has proposed changing the treatment of intentionally defective grantor trusts (IDGTs). Transfers to IDGTs are considered completed gifts and, thus, outside a grantor’s estate. However, for income tax purposes, the existence of the trust is disregarded: the grantor is considered the owner of the trust and is thus subject to tax on its income.
The grantor trust provisions were originally enacted to limit opportunities for individuals subject to income tax at the highest marginal rates from shifting a portion of their income to trusts subject to tax at lower marginal rates. The provisions operate by disregarding the trust for income tax purposes. The provisions have no effect on the other areas of US law that determine when a trust’s assets are excluded from the grantor’s estate. As the tax brackets for individuals and trusts have equalised, the public harm that the grantor trust provisions were enacted to prevent may no longer be significant. The greater harm, from the government’s perspective, appears to be the tax savings to be had from planning with IDGTs.
Returning to the above example, where a grantor gifted USD5 million to a trust and lent USD50 million, the loan could instead be structured as a sale of USD50 million of assets in exchange for a promissory note. If the trust is an IDGT, no gain is reported on the sale, and no interest income is reported by the grantor on the promissory note, because the trust is disregarded for income tax purposes and a person cannot sell assets or charge interest to themselves. Nevertheless, because the trust is respected for transfer tax purposes, its assets are not included in the grantor’s estate. This can facilitate the transfer of privately traded assets that would be difficult to value if left in the grantor’s estate. Although the grantor may not perceive this to be a benefit of IDGTs, as the trust’s owner for income tax purposes they are required to pay taxes on the trust’s income, and these payments are not treated as further gifts. In economic, but not legal terms, this is a tax-free gift to the trust’s beneficiaries.
Former proposals for limiting opportunities to plan with IDGTs focused on reducing opportunities to create grantor trusts. The Treasury Department’s latest proposal is far less welcome. It works the opposite way, by looking to the grantor trust provisions to reduce the circumstances in which a trust’s assets are excluded from the grantor’s estate.
Returning to the example above, the proposal would continue to disregard gain on the USD50 million sale and continue to disregard interest charged on the related promissory note. However, the transaction’s entire estate-tax benefit would be irrelevant because all the trust’s assets, including the USD5 million gift (which would not have been subject to gift tax when made), the USD50 million of assets sold to the trust, and all gains and income derived by the trust during the intervening years, would be included in the grantor’s estate. In effect, IDGTs would be defective for both income and transfer tax purposes.
‘The Treasury Department proposes to expand the list of characteristics that will cause a trust to fail for transfer tax purposes’
In other words, the Treasury Department proposes to greatly expand the list of characteristics that will cause a trust to fail to be respected for transfer tax purposes. For example, a trust permitted to make distributions to the grantor’s partner only in the trustee’s discretion might no longer be protected from estate tax on the grantor’s death, even if the trustee is independent, and even if the grantor cannot remove or replace the trustee.
Complementing the Treasury Department’s attempt to render a greater variety of newly formed trusts ineffective for transfer tax purposes are indications from the IRS that decanting and other transactions commonly assumed to have no tax effect may soon be more likely to be subject to income or transfer taxes.
Decanting effectively permits the trustee of an otherwise irrevocable trust to rewrite the trust by ‘appointing’ or ‘decanting’ its assets to a new, separate trust. Trustees often opt to decant trusts that would benefit from modern administrative positions. For example, the transferor and transferee trusts may be identical but for the updated administrative provisions in the latter. A trustee may find themselves in the position where the trust instrument provides them with the broadest authority to make distributions of principal and income but deprives them of the authority to determine the state in which the trust should be administered, or choose a substitute charitable beneficiary when the charity identified in the trust instrument has expired. Such shortcomings in the trust instrument can be rectified through decanting when modifications to the existing trust instrument are not permitted. More drastic modifications may be made by, for example, removing beneficiaries from the trust to which assets are decanted.
New York was the first US state to enact a statute permitting decanting, doing so in 1992 and further liberalising the statute in 2011. Other states have since followed, enacting increasingly flexible decanting statutes. In Notice 2011-101, the IRS requested comments on whether it should continue to permit decantings that have no tax effect to continue to use this tool.
Taken as a whole, 2012 may be a golden year for estate-tax planning because the USD5.12 million exemption amount has never been greater and may not be this great for many years to come, the sale/gift planning opportunities currently available with IDGTs may be eliminated and, if the Treasury Department gets its way, far fewer newly formed trusts will qualify for the estate-tax savings that trusts formed today can provide. Increasing IRS scrutiny, as shown by its stated intention to revisit the tax treatment of decantings, should be expected in all matters.
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