“Proposed Transfer Tax Changes” by Thomas D. Peebles, Jr. and Emily J. Kembell

Earlier this year, the Treasury Department released the Obama Administration’s 2013 Revenue Proposals, which include several recommended changes to the current federal transfer tax system (estate, gift and generation-skipping taxes). Six of the key proposals set forth in the Administration’s plan are summarized as follows:

1. Restore Transfer Taxes to 2009 Levels.
   For calendar year 2012, the applicable exclusion amount (or exemption) for estate, gift and generation-skipping taxes, indexed to inflation, is $5,120,000, and the tax rate for amounts in excess of the exemption is 35%. However, unless Congress acts, on January 1, 2013, the amount of the exemptions, the tax rate and the law governing transfer taxes will revert to the law in effect in 2001. That would result in an estate and gift tax exemption of $1 million, a GST exemption of approximately $1.4 million and a top tax rate of 55%.
   Rather than retaining the 2012 transfer tax rates and exemptions or permitting the 2001 rates and exemptions to apply, the Administration instead proposes to make permanent the estate, gift and GST tax laws as they applied in 2009. Under this proposal, the maximum tax rate would be 45%, the exemption amount for estate and GST taxes would be $3.5 million and the exemption for gift taxes would be $1 million. The proposal would be effective for estates of individuals dying, or for gifts made, on January 1, 2013, or later.
2. Make “Portability” Permanent.
   The 2010 Tax Act introduced a new concept into the federal transfer tax system: portability of the estate and gift tax exemption amount. Under the portability rules, the surviving spouse of a person who dies in 2011 or 2012 may be eligible to increase his or her own transfer tax exemption amount by the portion of the predeceased spouse’s exemption that remained unused at the predeceased spouse’s death (in other words, the exemption is “portable”). This portability of the exemption amount between spouses for both estate and gift tax purposes, however, is due to expire at the end of calendar year 2012. Under the Administration’s proposal, the portability rules contained in the 2010 Tax Act would be retained and made permanent.
3. Modify Rules on Valuation Discounts.
   In an effort to reduce the use of valuation discounts for family limited partnerships, limited liability companies and other family-owned entities, the Administration proposes that new valuation rules be enacted. The proposal would allow the IRS to disregard for estate and gift tax purposes certain restrictions that would otherwise reduce the appraised value of an interest in a family-controlled entity transferred from one family member to another. This proposal would be effective upon the date of enactment.
4. Require a Minimum Term for GRATs.
   A Grantor Retained Annuity Trust (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. GRATs can be structured so that the grantor’s annuity interest is essentially equal to the value of the assets transferred to the trust, so that no gift tax is imposed upon creation and funding of the trust. At the end of the annuity term, the assets remaining in the trust are transferred to (or held in further trust for) the beneficiaries, generally descendants of the grantor. If the trust assets appreciate in value during the GRAT term in excess of the amount required for the annuity payments, then such appreciated value is transferred to family members tax free. Particularly in these times of low interest rates, GRATs have proven to be a popular and efficient technique for transferring wealth while minimizing (or avoiding) the gift tax cost of transfers, provided that the grantor survives the GRAT term.
   The Administration’s proposal would require that a GRAT have a minimum term of ten years. This would prohibit the use of short-term GRATs (2 to 3 years) that have been widely used over the last several years and would increase the risk that the grantor will die during the GRAT term and lose the anticipated transfer tax benefits. The Administration’s proposal would also impose a maximum GRAT term of the grantor’s life expectancy plus ten years, would require the gift tax value of the remainder interest to be greater than zero at the time the interest is created and would prohibit any decrease in the annuity during the GRAT term. All of the proposed changes would apply to GRATs created after the enactment date.
5. Limit the Duration of the Generation-Skipping Transfer Tax (GST) Exemption.
   The GST tax is imposed on gifts and bequests made to individuals who are two or more generations younger than the person making the transfer (“skip persons”). Without a GST tax, it would be possible to avoid estate and gift tax liability through the use of trusts that give successive life interests to multiple generations of beneficiaries. However, each person has a GST exemption which can be allocated to transfers made to skip persons or to trusts for skip persons (“GST Trusts”). Accordingly, it is possible to “skip” transfer taxes on amounts equal to the GST exemption (currently $5,120,000), plus all appreciation and income on that amount during the existence of a GST Trust.
   At the time the GST provisions were first enacted, the law of most states included a common law Rule Against Perpetuities (RAP), or some statutory version of it, which prohibited trusts from continuing in perpetuity. The RAP limited, then, the amount of time that GST Trusts could exist and take advantage of the GST exemption. In recent years, many states (including Missouri) have repealed the RAP or lengthened the amount of time that assets can remain in trust. As a result, it is currently possible to create “Dynasty Trusts” which last in perpetuity and take advantage of the GST exemption forever.
   The Administration’s proposal would severely restrict the use of “Dynasty Trusts” by directing that a GST Trust would no longer be exempted from the GST tax after it has been in existence for 90 years. The proposal would apply to GST Trusts created after enactment and to the portion of an existing trust attributable to an addition made after the date of enactment.
6. Eliminate Intentionally
   Defective Grantor Trusts. The Grantor Trust rules for income tax purposes are not the same as the Grantor Trust rules for inclusion in the gross estate for estate tax purposes. As a result, it is possible to create a trust in which the Grantor pays the tax on the income earned by the trust (even though the income remains in the trust or is distributed to the trust beneficiaries) but the Grantor is not considered the owner of the trust for estate tax purposes. These types of trusts are often referred to as “Intentionally Defective Grantor Trusts” (IDGTs). One of the benefits of creating an IDGT is that each time the Grantor pays the income tax on the trust’s income and gains, the Grantor is effectively making an additional tax free gift to the trust. The creation of IDGTs and subsequent sale of assets by the Grantor to the IDGT has been a very popular and effective technique, and the Treasury obviously would like to eliminate this planning tool.
   The Administration’s proposal is that whenever a trust is classified as a Grantor Trust for income tax purposes then (1) the assets of the trust will always be included in the Grantor’s estate at the Grantor’s death for estate tax purposes, (2) distributions from the trust during the trust term will be considered a gift by the Grantor, and (3) any assets in the trust when the Grantor ceases to be the Grantor for income tax purposes is subject to gift tax. The proposal will, effectively, terminate the traditional planning techniques using IDGTs. The proposal would be effective with regard to trusts created on or after the date of enactment and to any portion of an existing trust attributable to a contribution made on or after the date of enactment.
7. Summary.
   It is important to note that these are proposals only; the Administration’s “wish list” for provisions impacting the estate, gift and GST tax law. Given the current political situation in Washington, D.C., the ability of the Administration to get all or any of these proposals enacted is questionable. Still is it useful to understand where Treasury wants to impact traditional estate and transfer tax planning. Clients considering one or more of these estate planning techniques may very well want to move forward now with their planning so as not to be restricted if any of these proposals are, in fact, enacted. Specifically, clients may wish to (1) take advantage of the current $5,120,000 exemption for estate, gift and GST tax purposes; (2) proceed with the use of valuation discounts in making gifts of family controlled entities to family members; (3) create Dynasty Trusts utilizing the current GST exemption for trusts designed to continue in perpetuity; (4) create short-term GRATs before they are eliminated; and (5) create IDGT’s now to take advantage of current law.

Please contact any member of the Estate Tax Planning Practice Group (Cliff Brown, Tom Peebles, Doug Lee, Jennifer Huckfeldt, Emily Kembell, John Carnahan or Bill Evans) with questions regarding these proposed changes in the law and/or the estate planning techniques which would be impacted by these proposed changes.