What to do with Inherited Property in 2010?

With the repeal of the Estate Tax and Generation Skipping Transfer Tax in 2010, those who inherit assets from someone who dies in 2010 may be forced to deal with some very difficult income tax basis rule changes. If someone dies and their entire estate is less than $1.3M the inherited assets will receive a "step-up" in basis to the fair market value of the asset as of the decedent's date of death. But, if the person who dies in 2010 owned more than $1.3M in assets, then a tax return must be filed with the decedent's final income tax return which would be due April 15, 2011 or such later date as the IRS might prescribe by regulation not yet issued [see IRC Section 6075(a)].

If an heir sells property in 2010 where the asset is included in an estate of a deceased person with more than $1.3 M in property, that individual will need to wait until he or she receives the information required by Internal Revenue Code Section 6018. So far, the IRS has not even published the necessary tax forms to file this report.

Heirs who inherit property from someone who dies in 2010 in excess of $1.3M would do best to NOT sell that asset in 2010. There is an argument that with the sunset of the current tax laws at the end of this year (Section 901 of the EGTRRA) that the basis of assets sold after 2010 from decedents dying in 2010 will be entitled to a step-up in basis under the resurrected Section 1014 of the Internal Revenue Code. No one can say for sure what Congress might do before the end of the year? Stay tuned.

Generation Skipping Issues in 2010

Like the federal Estate tax, the federal Generation-Skipping Transfer ("GST") tax is currently repealed for 2010. If Congress continues on its "do nothing" approach to tax reform, the GST tax will reappear on January 1, 2011 at a top rate of 55%.

Unlike the estate tax where one has to die in 2010 to benefit from the repeal, there are some options this year for those who are planning on living until 2011. By way of background, the GST tax was implemented by Congress in 1976 as a way to stop rich people from passing wealth down to future generations tax free. It was designed to tax distributions that did not get passed down from one generation to the next (i.e. parent to child) by taxing distributions that "skipped" a generation. Thus, in addition to income tax, estate tax, and gift taxes Congress leveled a new tax (the GST tax) for transfers that are classified as "generation skipping transfers" to or for the benefit of a "skip person". This system was so complicated that Congress decided in 1976 to give every taxpayer a $1M dollar exemption from GST taxes. In 1976 $1M was a lot of money. From 1976 to 2001 the GST exemption was increased to $1, 060,000. Suddenly, people who had never heard of the GST tax [Chapter 13 of the Internal Revenue Code] were paying more in taxes. Congress ratcheted the exemption up to $3,500,000 by 2009. We are now poised for the return of the GST tax on January 1, 2011 at the base rate of $1M with perhaps some minor inflation adjusted amount.

A skip person is generally a person more than one generation removed (think grandchild and beyond) from the transferor. A skip person can also include a trust for the benefit of beneficiary or beneficiaries of a skip person(s). A generation skipping transfer can be either:

1. a "Direct Skip" which is an outright transfer to a skip person or a trust for a skip person;
2. a "Taxable Distribution" from a trust to a skip person; or
3. a "Taxable Termination" of a trust or non-skip person's interest in a trust that vests property in a skip person, which could include the termination of all non-skip persons' interests in the trust, leaving only skip persons as beneficiaries.

Certain trusts may be "GST Exempt" trusts because they were set up before the date of the enactment of the GST tax (i.e. they are "grandfathered") or the maker of the trust allocated his or her GST exemption on a validly filed GST tax return to allow the GST Exempt trust to have an inclusion ratio of "0".

Several planning opportunities present themselves in 2010. For example, a donor can make direct gifts to grandchildren without any GST tax in 2010. However, the federal Gift tax still remains in effect. The highest federal Gift Tax rate for 2010 is 35%. Gifts that are less than $13,000 per donee per calendar year are exempt from gift tax. In addition, a person may allocate any part of their $1M dollar lifetime gift tax exemption to such gifts. Note that the gift tax rate is down 10% from last year (45%) and will be 20% less than the projected current gift tax rate of 55% for next year.

If a grandparent who has exhausted all of one's annual exclusions and gift tax exemption were to gift $1,000,000 to a grandchild this year, the transfer tax would be $350,000. That same gift if made in 2011 would incur a combined gift tax and GST tax liability of $1,100,000! That is a tax rate of 110%! If a grandparent were to make gifts to great-grandchildren, such gifts would skip two generational levels.

Many grandparents have established gift trusts for grandchildren. Each calender year the grandparent would gift $13,000 into such a trust for the benefit of the grandchild. Normally Section 2611 (b)(2) of the Code would protect future distributions from such trusts from GST tax in the future since the original transfer to the trust was subject to GST. A transfer to such a trust in 2010,however, would NOT be subject to GST. There fore, the protection of Section 2611 (b)(2) may not apply. Accordingly, grandparents should not make annual exclusion gifts to gift trusts in 2010. Instead, one may wish to consider either direct transfers to skip persons or to a Uniform Transfer to Minors Account for such a grandchild in 2010. Consideration needs to be given to the appropriateness of such gifts to a grandchild outright.

Grantor Retained Annuity Trust ("GRAT")

The Grantor Retained Annuity Trust (often referred to as a "GRAT") is a long favored technique for those with substantial estates who find themselves staring at a 55% estate tax rate starting January 1, 2011. By setting up a GRAT one can legally pass wealth down to the next generation on a tax favored basis. In essence, a donor sets up an Irrevocable Trust and retains the right to receive an annuity paid to the donor over a specified term of years. At the end of the annuity term, if there is anything left over for the beneficiaries, known as "remaindermen", the amount of increase in the trust's investments that exceeds a specified rate set by the IRS, passes tax free to the remaindermen.

The IRS hates this technique even though it is sanctioned by the current tax Code. Clients often set up revolving GRATS that rollover at the end of the term as a way to leverage their transfers to younger beneficiaries. Typically, we use GRATS that have a term of two, three or sometimes five years.

On July 1, 2010 the House of Representatives voted 215 to 210 to pass an amendment to H.R. 4899 ( a supplemental spending bill) that would now require all GRATS to have a minimum ten year term. If the donor who sets up a GRAT dies during the term, the bulk of the GRAT is includable in the estate of the donor for Federal Estate Tax purposes. Thus, for older donors this may well be the death knell of the use of the GRATS. The Senate is expected to take the measure up in the next few days.

For anyone interested in setting up GRATS, now is the time to do so! The effective date of the legislation will be the date the Act is enacted. Due to the very low interest rates now in play, if anyone has ever considered this technique, they should rush to get this accomplished post haste to avoid the application of the ten year minimum term rule. It looks like the clock will be ticking down soon.

The Closely Held Business - What to do?

Estate planning attorneys are always talking with clients about how to best plan for their retirement and estate planning. For those clients who own a business, planning for the transfer of that business upon death or disability must be built into the process. The challenge of how to treat both the family and the employees of the business fairly is a difficult challenge.

Current Climate for Business Transfers

With the aging of the baby boomers, there are more and more closely held businesses coming onto the market every month. There may be a myriad of more sellers than qualified buyers. Coupled with the current stock market losses, these factors affect the value of one's closely held business. Coupling that with increased governmental regulation in all areas of the law dealing with commerce, labor, anti-discriminatory employment practices, new tax laws and the like, the small closely held business is under assault. Trying to get a bank to make a loan to buy a closely held business is almost impossible given the increased standards of the banking and finance industries. And, to top it off, for the first time in years individual income tax rates are increasing to exceed corporate income tax rates. Income taxes next year could be as high as 39.6% for an individual ( federal rate), plus 6% for Missouri state income tax, with any a new 3.8% healthcare tax on higher incomes. We are now looking at a first-time Medicare tax on passive income. Long-term capital gains tax rates will be increasing from 15% to 20 - 28%. And, if Congress fails to act, estates of more than $1M dollars starting on January 1, 2011 will be taxed at 55%.

Public corporations can pass along their increased costs to the consumers. But, a privately owned company must absorb these increased costs out of what goes to the owners of the business. If a private business wants to borrow money to keep a business afloat, the owners will have to sign a personal guaranty with the bank pledging their personal assets for the business loan. If the business fails, often the fortunes of the family go with the business.

The analysis has to start with "What does the client want?" Here it is often difficult for clients to resolve inherent conflicts. How does a business owner treat children who work in the business with those who work outside the business? Is the goal to pass the business down to the next generation? Who will provide the management of the transferred business? Are the children of the owners the best "qualified" people to lead the company? Sometimes bringing in an outside consulting firm to give the owners an unbiased opinion is a good start to the succession planning process. Retaining employees who feel that they have merited consideration can be extremely difficult in a business succession plan. Protecting the business's good will through contracts with key employees that restrict competition, or soliciting customers or vendors and employees are critical components in maximizing the valuation of the business.

The very best time to sell a business to maximize it's value is when things are going well. Unfortunately, this is the very last thing a successful closely-held business owner is thinking about until some disastrous event occurs. The transfer of a company has to be incorporated in the client's retirement, estate and income tax planning.

Leaving a Legacy

I like to define estate planning as giving what you want, to whom you want, the way you want, how you want, and at the lowest possible cost. That definition has always made a lot of sense to me. But, that definition is really focused on estate planning as a process. What makes even more sense is to think of how one's estate plan can add value to others. The joy of giving is difficult for many to grasp. But, when one gives something of value that reflects a donor's hopes, dreams and goals there is demonstrable benefit to the donor. It is, I believe, an universal law of nature. When you gives some thing away of value, there is a benefit that comes back to the donor. It may not be economic; but, there is joy in helping others to achieve a goal. That joy is brought about by leaving a legacy. A legacy is a benefit that survives the donor. It comes from the realization that we enter this world with nothing and when we die, we can't take it with us. So what does one do with the accumulation of wealth? This has nothing to do with the quantity of wealth; but, everything to do with the quality of one's estate plan.

If someone fails to do any planning at all, the State determines who will benefit. This is called the law of Intestate Succession. For example, in Missouri if someone dies while they are married with children, the spouse will receive the first $20,000 of assets. The balance is then divided between the spouse and the children. If a single person dies without descendants, the estate passes in equal shares between the mother, father, brothers and sisters. Many times when people discover this, they will say, "That is not what I want!" This is why it is important for every person, regardless of the size of one's estate, to create an estate plan long before the need arises.

New Wyoming Single Member Limited Liability Company

I remember back in 1977 when the State of Wyoming passed the first Limited Liability Company Act. Many thought that a hybrid company that could be treated as a partnership or proprietorship for tax purposes and yet have limited liability like a corporation would never work. Fast forward to today and all fifty states now have Limited Liability Company statutes and the Limited Liability Company ("LLC") has become the entity of choice for all of new business organizations.

Well, the state of Wyoming is at it again. Beginning July 1, 2010 , an individual can set up a single person LLC in Wyoming and have creditor protection in a way that is not available in Missouri or in very few states. The new provision of the Wyoming statute regarding creditor's rights (W.S 17-15-503) now creates an "exclusive remedy" for creditors of an LLC. A creditor is limited to what is known as a "charging order". The charging order "is the exclusive remedy by which a person seeking to enforce a judgment against a judgment debtor, including any judgment debtor who may be the sole member, disassociated member or transferee, may, in the capacity of the judgment creditor, satisfy the judgment from the judgment debtor's transferable interest or from the assets of the limited liability." This means the individual member of the LLC (think "owner") cannot be sued for the liabilities of the LLC. The Wyoming statute even goes on to say that there are "no other rights, legal or equitable, other than the charging order". Thus, there is no judicial foreclosure available to a creditor of a member's LLC ownership interest.

Anyone who is interested in creating an extra layer of security in a business enterprise might consider setting up a single member Wyoming LLC and then registering the Wyoming LLC as a foreign business in the state in which the member resides or does business. We can partner with attorneys who are licensed in Wyoming to assist clients with this new tool of asset protection planning.

2010 Estate Planning

As of June 8, 2010 Congress has still failed to act to advise us as to what the exact tax implications will actually be for people who die in 2010. With the repeal of the Estate Tax and Generation Skipping Transfer ("GST") tax in 2010, anyone who contemplates that they could meet their demise in 2010 would be well advised to seek legal counsel immediately to update one's estate planning documents. In particular, anyone who utilizes a "formula clause" in one's will or trust to create sub-trusts after the first spouse's death for the benefit of a surviving spouse and/or family members (i.e. a "Marital Trust" and a "Family Trust") would be well advised to update his or her documents.

For larger estates the gift tax rate this year is at an all time low of 35%. Next year, the rates revert to 55%. Should one consider making taxable gifts this year to pick up a 20% savings for the benefit of one's heirs? Anyone who has to write a check to the "U.S. Treasury" next year for 55% rates would have thought that this would have been a wonderful idea!

Clients who face end of life issues may wish to update their Health Care Powers of Attorney and Living Wills in light of the year end tax issues for 2010. The time to make these decisions is well in advance of the events that cause the need for them.

Our best guess at this time is that we are not going to see any tax legislation before the November elections. Given the current circumstances of gridlock in Washington D.C. at this time, the thought of comprehensive tax legislation getting done before year end is looking more and more unlikely. We very well may be facing a situation starting on January 1, 2011 where every unmarried citizen who dies in 2011 will be paying 55% estate taxes on one's estate in excess of $1M dollars.