United States: Window For Estate Tax Savings May Be Closing

The current favorable estate, gift and generation skipping transfer (GST) tax laws are set to expire on December 31, 2012. We are urging our clients to contact us by June 1, 2012 to allow sufficient time to engage in immediate planning under the current favorable laws. The ability to transfer $5.12 million per person ($10.24 million for a couple) in tax-free gifts expires December 31, 2012.

This Paul Hastings Client Alert focuses on the short-term opportunities available under the current U.S. gift, estate and GST tax laws and the long-term estate, gift and GST tax proposals under President Obama's 2013 Revenue Proposals.

Estate Tax Savings Deadline is Approaching

For the first time in history the estate, gift and GST tax exemptions are $5,120,000 per person ($10,240,000 per married couple). However, the current favorable laws are scheduled to expire on December 31, 2012.

* Without Congressional action.

Under the current law, the estate and gift tax exemption amounts are "portable" between spouses. Surviving spouses may use the predeceased spouse's unused estate tax exemption amount to make additional lifetime gifts and estates of decedents may apply the predeceased spouse's unused estate tax exemption amount.

Beginning on January 1, 2013, however, without interim congressional action, the gift, estate and GST tax exemption amounts will revert to the previously high tax rate of 55%, with an exemption of $1,000,000 per person ($2,000,000 per married couple). The "portability" of gift and estate tax exemption amounts will not be available to surviving spouses.

The Obama Proposal

The White House recently released President Obama's 2013 Revenue Proposal (the "Obama Proposal"), which proposes to restore the 2009 gift, estate and GST tax parameters. This would increase the tax rate for the estate, gift and GST tax to 45% and lower the gift tax exemption to $1,000,000 per person ($2,000,000 per married couple). The estate and GST tax exemptions would be lowered to $3,500,000 per person ($7,000,000 per married couple).

The Obama Proposal also seeks to make permanent the "portability" law so a surviving spouse will be able to use his or her predeceased spouse's unused estate tax exemption amount to make additional lifetime gifts and estates of decedents may apply the predeceased spouse's unused estate tax exemption amount subject to certain restrictions.

The Obama Proposal contains several surprisingly disadvantageous additional provisions as follows:

• Eliminate the Estate Planning Benefits of Grantor Trusts: Under the current law, transactions between an individual (the "grantor") and a "grantor trust" are ignored for income tax purposes, but a grantor trust is still a separate legal entity for estate and gift tax purposes. Thus, a grantor trust provides an estate planning benefit because the income tax consequences are similar to the grantor making a gift tax-free transfer of the income taxes to the grantor trust each year – thus allowing the assets in the grantor trust to grow undiminished by income tax payments.
  
  The Obama Proposal dealing with grantor trusts would (1) include the assets of a grantor trust in the gross estate of the grantor for estate tax purposes, (2) subject to gift tax any distribution from a grantor trust to one or more beneficiaries during the grantor's life, and (3) subject to gift tax the remaining trust assets at any time during the grantor's life if the grantor ceases to be treated as an owner of the grantor trust for income tax purposes. The proposal would be effective with regard to grantor trusts created on or after the date of enactment and with regard to any post-enactment contributions to a pre-enactment trust. Thus, this proposal is another reason for clients to consider large gifts and sales to grantor trusts prior to December 31, 2012.
• Require a Minimum Term for a Grantor Retained Annuity Trust (GRAT): Generally, a GRAT is an irrevocable trust funded with assets expected to appreciate in value, in which the grantor retains an annuity interest for a term of years that the grantor expects to survive. At the end of that term, the assets remaining in the trust are transferred to (or held in further trust for) the beneficiaries, who generally are descendants of the grantor. If the grantor dies during the GRAT term, however, the trust assets (at least the portion needed to produce the retained annuity) are included in the grantor's gross estate for estate tax purposes. To this extent, although the beneficiaries will own the remaining trust assets, the estate tax benefit of creating the GRAT (specifically, the tax-free transfer of the appreciation during the GRAT term in excess of the annuity payments) is not realized.
  
  GRATs have proven to be a popular and efficient technique for transferring wealth while minimizing the gift tax cost of transfers, providing that the grantor survives the GRAT term and the trust assets do not depreciate in value. The greater the appreciation, the greater the transfer tax benefit achieved. Furthermore, the Obama administration has realized that taxpayers have become adept at maximizing the benefit of this technique, often by minimizing the term of the GRAT (thus reducing the risk of the grantor's death during the 3 term), in many cases to two years, and by retaining annuity interests significant enough to reduce the gift tax value of the remainder interest to zero or to a number small enough to generate only a minimal gift tax liability.
  
  This proposal would impose a requirement that a GRAT have a minimum term of ten (10) years and a maximum term of the life expectancy of the annuitant plus ten years. The proposal also would include a requirement 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 will fail to outlive the GRAT term and the resulting loss of any anticipated transfer tax benefit. Thus, this proposal is another reason for clients to consider GRAT planning prior to December 31, 2012.
• Eliminate Lack of Control Discount Afforded to Family Limited Partnerships and LLCs: A family limited liability company ("FLLC") is commonly used to transfer wealth for gift, estate and GST tax purposes. Typically, a FLLC is formed and funded with the family's business interests, hard-to-value assets or assets subject to liability risk. Over time, parents make gifts of a percentage of their ownership interest in the FLLC to grantor trusts for their children or grandchildren. Due to the closely held business nature of the FLLC, the ownership interests transferred are often subject to significant valuation discounts, such as lack of control and lack of marketability discounts, for gift and estate tax purposes. This proposal, effective on the date of enactment, would eliminate the significant valuation discounts afforded to FLLCs. This proposal is another reason for clients to consider large gifts of FLLC ownership interests prior to December 31, 2012.
• Impose a 90-Year Limit on GST Tax Exempt Dynasty Trusts: Under current California law, every irrevocable trust either must provide that it will terminate no later than 21 years after the death of a person who was alive at the time of the creation of the trust or actually terminate no more than 90 years after it was created. This rule is known as the Rule Against Perpetuities ("RAP"). Many states now either have repealed or limited the application of their RAP statutes, with the effect that trusts created subject to the law of those jurisdictions may continue in perpetuity. If such trust is a GST Tax exempt trust, the assets of such trust and any appreciation may pass to future generations for the length of the RAP or if repealed, into perpetuity. This proposal would provide that, on the 90 anniversary of the creation of a GST Tax exempt trust, the GST exclusion allocated to the trust would terminate and force estate tax inclusion into the estates of the then income beneficiaries. This proposal would apply to trusts created after enactment, and to post-enactment contributions to a preexisting trust. Although this proposal would not have a large effect on trusts established under California law, it would reduce significantly the benefits of establishing a GST Tax exempt trust under the laws of other states that have repealed their RAP laws, such as Delaware. This proposal is another reason for clients to consider gifts or sales to dynasty grantor trusts prior to December 31, 2012.

Outright Gifts

The simplest way to take advantage of the current high gift and estate tax exemption is to make a significant gift of assets to a "grantor trust" created for a child or grandchild or other beneficiary. As discussed above, transactions between the parent and a "grantor trust" are ignored for income tax purposes, but a grantor trust is still a separate legal entity for estate and gift tax purposes. Thus, a grantor trust provides an estate planning benefit because the income tax consequences are similar to the grantor making a gift tax-free transfer of the income taxes to the grantor trust each year – thus allowing the assets in the grantor trust to grow undiminished by income tax payments.

Assets expected to highly appreciate are best for outright gifts to grantor trusts, however, an outright gift of cash or securities to a grantor trust is always an option.

Clients with a diverse asset portfolio should consider the following transactions to efficiently leverage their $5,120,000 gift tax exemption amount.

Low Interest Rate Planning Opportunities

The current low interest rate environment presents unique wealth transfer opportunities that allow entrepreneurs, private equity investors and high net worth individuals the opportunity to pass large amounts of wealth to children, grandchildren and charities, gift and estate tax-free.

Due to the current interest rates and discounting opportunities, 2012 is an ideal time to gift (i) assets which have recently depreciated in value if such assets are expected to experience future appreciation, and (ii) hard-to-value assets, including closely held business interests.

Intrafamily loans, family limited partnership planning, short-term grantor retained annuity trust planning and sale to grantor trust transactions continue to provide substantial benefits for our clients.

Intrafamily Loans to Grantor Trusts

The interest rate cuts issued by the Federal Reserve have affected two important interest rates used in estate planning – the "applicable federal rates" ("AFRs") under Internal Revenue Code Section 1274 and the "7520 rate" under Internal Revenue Code Section 7520. AFRs are calculated and published by the IRS every month and represent the minimum rates of interest that must be charged to debt instruments to avoid imputed interest for gift and income tax purposes. The 7520 rate is also calculated and published each month by the IRS and represents the interest rate used to calculate the present value of term interests, life interests, annuities and remainder interests.

The AFR rate for April 2012 for a mid-term note is only 1.15%. The 7520 rate for April 2012 is 1.4%.

The simplest way to take advantage of current low interest rates for estate planning purposes is through the use of intra family loans. Typically, a parent (or other family member) loans money to a "grantor trust" created for a child or grandchild. Transactions between the parent and a "grantor trust" are ignored for income tax purposes, but a grantor trust is still a separate legal entity for estate and gift tax purposes. Thus, a grantor trust provides an estate planning benefit because the income tax consequences are similar to the grantor making a gift tax-free transfer of the income taxes to the grantor trust each year – thus allowing the assets in the grantor trust to grow undiminished by income tax payments. In exchange for the loan to the grantor trust, the parent receives a promissory note for the amount loaned, plus interest at the AFR corresponding to the month that the loan was made and for the length of time of the note. The payment terms under the note may be flexible.

For example, a promissory note given in April 2012 for nine years would carry an interest rate of 1.15% and could require only interest payments until the maturity date, at which time the entire note would become due and payable. If the trustee of the grantor trust for the child or grandchild can invest the borrowed funds and achieve a greater rate of return on the investments over a period of nine years than the 1.15% interest rate on the note, the grantor trust for the child or grandchild will retain the excess and will have done so gift and estate tax-free.

Because transactions between the grantor trust and the parent are ignored for income tax purposes, the parent does not have to report the interest received on the note as income, nor is there an interest deduction for the grantor trust. Both the grantor trust for the child or grandchild and the promissory note should be adequately documented. There should be a real expectation of repayment to avoid an argument by the IRS that the transaction is really a disguised gift.

Family Limited Liability Company Planning

A family limited liability company ("FLLC") is commonly used to transfer wealth for gift, estate and GST tax purposes. Typically, a FLLC is formed and funded with the family's business interests, hardto- value assets or assets subject to liability risk. Over time, parents can make gifts of a percentage of their ownership interest in the FLLC to grantor trusts for their children or grandchildren. Due to the closely held business nature of the FLLC, the ownership interests transferred are often subject to a significant discount for gift tax purposes.

In addition to outright gifting of FLLC interests, FLLC interests are transferred to future generations through certain advanced estate planning transactions, discussed below.

Grantor Retained Annuity Trust ("GRAT") Planning

A GRAT is a trust codified by Internal Revenue Code Section 2702 commonly used to transfer the appreciation on assets from parents to children without incurring federal gift or estate tax.

A GRAT involves transferring property that is expected to appreciate significantly over time – such as a closely held business, pre-IPO stock or a private equity investment – to a GRAT trust instrument. In return, the individual who established the trust (the "Grantor") receives an annual annuity payment for each year the GRAT is in existence. The amount of the annuity payment is based on the value of the assets transferred to the GRAT, the number of years the GRAT will exist and the applicable interest rate mandated by the IRS (known as the Section 7520 rate). At the end of the GRAT term the assets remaining in the GRAT may be transferred to trusts for the children.

Many GRATs are limited to a term of 2-7 years because the success of a GRAT depends on two risk factors: (1) whether the Grantor survives the term of the GRAT (the "mortality risk"); and (2) whether the assets transferred to the GRAT outperform the 7520 rate (the "investment risk"). If the Grantor dies during the term of the GRAT, some value of the GRAT assets may be included in the Grantor's estate for estate tax purposes – thus reducing the tax benefits of the GRAT. As a result, GRATs are often structured with shorter terms in order to minimize the mortality risk.

A shorter 2-7 year GRAT is also used to overcome the investment risk. For example, if a parent owns pre-IPO stock or other investment which is likely to increase rapidly in 2-7 years, the appreciation, through the GRAT trust, can be transferred from the parent to the children. For a longer term GRAT, however, the investment risk increases. If the assets contributed to the GRAT lose value or do not outperform the Section 7520 rate over a longer period of time, such as a 10-year term, there will be no assets remaining in the GRAT at the end of the term to transfer to the children.

Sale of Assets to Grantor Trusts

A very similar estate planning technique that works well in an environment of low interest rates is a sale of assets to a grantor trust. Closely held business owners, including FLLC owners, and private equity investors are typical clients for sales to grantor trusts. In a typical sale transaction, the parent/grantor "sells" an asset that is expected to appreciate over time to a grantor trust for a child or grandchild in exchange for a promissory note.

The asset should be an income-producing asset. The income on the asset is used to pay off the note during the term. The promissory note is often structured as a nine year interest-only note with a balloon payment at the end of the ninth year. Thus, the interest rate that would apply to such a note would be the mid-term AFR for the month of the sale. If the assets of the grantor trust allow for the payoff of the note and further appreciation, then the appreciation of the asset in the grantor trust for the benefit of the children or grandchildren at the end of the note's term is transferred free of gift tax.

There is also no capital gain recognized by the parent/grantor when the assets are sold to the grantor trust (for income tax purposes, the sale is treated as being made between the parent and himself or herself). Because of the fairly long term of the note, it is reasonable to expect that the investment return of assets sold to the grantor trust will be greater than the note's low interest rate.

There are several potential pitfalls to be aware of when utilizing this sale technique. First, if the parent/grantor dies during the term of the promissory note, the unpaid portion of the note will be included in the estate of the parent/grantor. Also, it is important that the grantor trust is adequately capitalized before the sale in order for the transaction to be respected by the IRS. This must often be done through a "seed" gift by the grantor to fund the trust (if the trust does not already have adequate assets). The various fees for a sale to grantor trust transaction are often higher than a straight loan of cash to a grantor trust. The asset sold must be professionally appraised to establish the sale price. The documentation for the sale is similar to the sale of a business and will require a purchase and sale agreement, a pledge of security, title transfers and other documentation.

To access prior Paul Hastings Client Alerts regarding additional wealth transfer opportunities, please visit: http://www.paulhastings.com/publicationslist.aspx

Conclusion

We strongly recommend that our clients review their existing estate plans and contact us before June 1, 2012 to discuss the impact of the current transfer tax laws on their planning and the significant wealth transfer opportunities for them and their families in 2012.

The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.