Analysis of the Obama Administration’s Fiscal Year 2015 Revenue Proposals of Importance to Estate Planners: Part I – Transfer Tax Proposals

The General Explanations of the Administration’s Fiscal Year 2015 Revenue Proposals released last month (the “Proposals”) contains several provisions that would affect estate planning clients.  Most of the provisions have been included in the Administration’s prior Proposals, but a couple of new provisions have been added.

Part I of this post deals with transfer tax changes in the Proposals.  Part II will deal with other changes in the Proposals that would affect estate planning clients.

Restore the Estate, Gift, and Generation-Skipping Transfer (“GST”) Tax to 2009 Levels

The current estate, gift and GST tax top rates and exclusion are, respectively, 40% and $5,000,000 indexed for inflation since 2010 ($5,340,000 for 2014).  This Proposal would restore the rates and exclusions to 2009 levels: i.e., a top rate of 45% and exclusions of $3,500,000 for estate and GST tax and $1,000,000 for gift tax, none of which would be indexed for inflation.

Under this Proposal, a deceased spouse’s unused exclusion (“DSUE”) amount would continue to be portable and available to the surviving spouse.  The current Proposal makes it clear that there would be no “clawback” (i.e., no gift or estate tax would be incurred by reason of the donor having used exclusion in excess of the reduced exclusion amount to offset the gift tax on gifts made prior to the change).

The Administration has included substantially similar provisions in each of its Proposals since President Obama took office in 2009.  Obviously, the provision was not enacted in 2010 (when the gift, estate and GST tax exclusions all were increased to $5,000,000 indexed for inflation and the top rate was reduced to 35%), in 2012 (when the exclusion amounts increased to $5,120,000 and the top rate was increased to 40%), in 2013 (when the exclusion amounts increased to $5,250,000) or 2014 (when the exclusion amounts increased to $5,340,000).  The change would become effective in 2018.

The stated reason for the change is that the government cannot afford to continue the tax cuts retained for the most affluent taxpayers under the American Taxpayer Relief Act of 2012 (“ATRA”) and the need for laws that are fair and raise an appropriate amount of revenue.

If this Proposal is enacted, it would materially increase the transfer tax burden on our wealthier clients after 2017.  As 2018 approaches, clients may want to consider gifts to utilize the exemption amounts over $3,500,000 that they would lose under this Proposal.

Consistency in Value for Transfer and Income Tax Purposes

A donee’s income tax basis in property received by lifetime gift generally is the same as the donor’s basis, plus gift tax paid on the gift.  The basis of property received from a decedent generally is the fair market value of the property on the decedent’s date of death.  The Administration’s concern is that recipients of property by gift or by reason of death may be overstating the basis of the property.  This could lead to the recipients claiming more expenses than they are entitled to on depreciable property and realizing less gain than they should when they dispose of the property.

This Proposal would require a recipient’s basis in property received by gift and from a decedent to be no greater than the value of the property for gift or estate tax purposes.  In order to allow for enforcement of the requirement, the provision would impose a duty on a donor of a lifetime gift or the executor of a decedent’s estate to report valuation and basis information to both the recipient and the IRS.  Instructions for gift tax and estate tax returns currently require information concerning value and basis despite the fact there is no statutory requirement.

The Administration has included similar provisions in each of its Proposals since President Obama took office.  The change would become effective the year after enactment.

The provision would likely have little impact on most of our clients; however, there may be instances where there is a conflict of interest between an executor (who is responsible for determining the value of assets for estate tax purposes) and a beneficiary who receives an asset.  Conflicts may become more common now that the top income tax bracket and top estate tax bracket are approximately the same.

Require a Minimum Term for Grantor Retained Annuity Trusts (“GRATs”)

GRATs are a type of irrevocable trust that allows a grantor to retain the right to an annuity payment for a term after which the remainder interest in the property passes to other beneficiaries.  The Administration’s concern is that current law potentially allows too great a benefit from the use of GRATs.  By minimizing the length of the term of a GRAT, the grantor can minimize the risk of death during the term of the GRAT (which would result in the inclusion of at least a portion of the property in the grantor’s estate).  By retaining a significant annuity interest in a GRAT the grantor can reduce the value of the remainder interest, which is considered a gift on the creation and funding of the GRAT, to a very small amount or zero.

Under current law, if the assets contributed to a short-term GRAT (e.g., a GRAT with a two year term) appreciate at a rate greater than the Section 7520 rate used to determine the value of interests in the GRAT, then the grantor can transfer assets to the remaindermen without any gift tax cost.  Moreover, if the Section 7520 rate increases materially during the term of a long-term GRAT (i.e., 99 years), then less than all of the assets in the GRAT would be included in the gross estate of the grantor, allowing the transfer of assets without the imposition of transfer tax.

This Proposal would require GRATs to have a minimum term of 10 years and a maximum term of the life expectancy of the grantor plus 10 years.  The purpose of the minimum term is to increase the risk that the grantor would not survive the term of the GRAT.  This Proposal also would require that the value of the remainder interest be greater than zero and that the annuity amount could not decrease during the term of the GRAT.

The Administration has included similar provisions in each of its Proposals since President Obama took office.  The change would apply to trusts created after the date of enactment.

Clients who have been considering the use of a GRAT in their planning may not want to delay creating them.

Limit Duration of Generation-Skipping Transfer (“GST”) Tax Exemption

The GST Tax Exemption allows gifts and testamentary transfers to trusts that can continue in existence for as long as allowed by the rule against perpetuities (“RAP”) period under applicable state law.  Such a trust can benefit multiple generations without the imposition of any transfer tax.  The Administration’s concern is that since the enactment of the current GST tax regime in 1976 almost half of the states have repealed or significantly extended the RAP period for trusts created under their laws.  For example, in 1976 the RAP period for trusts created under the laws of Florida was 21 years after the death of a person who was alive when the trust was created.  Florida changed its RAP during 1988 to allow trusts to continue for up to 90 years from the creation of the trust; and again beginning in 2001 to allow trusts to continue for up to 360 years from the creation of the trust.

This Proposal provides that the GST Exemption of a trust would terminate 90 years after its creation, thus ending the ability to create dynasty trusts that avoid the federal transfer tax regime for more than 90 years, regardless of the RAP period of the applicable state.

The Administration has included similar provision in each of its Proposals for four consecutive years.  The change would apply to trusts created after the date of enactment; and to additions to existing trusts after the date of enactment.  Trusts existing on the date of enactment would be grandfathered (unless subsequent additions were made to the trust).

The change would put our clients who create GST trusts after its enactment in the same position they would have been in prior to 2001 and put trusts created in all states on equal footing for purposes of the GST tax.

Coordination of Certain Income and Transfer Tax Rules Applicable to Grantor Trusts

A grantor trust is a revocable or irrevocable trust the assets of which the grantor is treated as owning directly for income tax purposes.  Transactions between the grantor and the trust are ignored for income tax purposes.  Moreover, because the grantor is required to pay income tax as if he or she owned the assets of the grantor trust directly, the assets owned by a grantor trust can grow free of income tax.  An irrevocable grantor trust can be structured so that the assets in the trust are not subject to estate tax at the death of the grantor.  The Administration’s concern is that the use of irrevocable grantor trusts allows opportunities for the transfer of significant wealth without the imposition of gift or estate tax.

This Proposal would limit the benefit of transactions between a grantor and an irrevocable grantor trust.  If the grantor engages in a sale, exchange or similar transaction with the trust that is ignored for income tax purposes under the grantor trust rules, then (1) the portion of the trust attributable to the property received by the trust in the transaction (including all subsequent net income therefrom and appreciation thereon) less (2) any consideration received by the grantor in exchange for the property transferred to the grantor trust would be subject to transfer tax in the future.  Such portion would be subject to gift tax during the grantor’s life if either (1) the grantor trust status terminates or (2) the property is distributed from the grantor trust to a third party.  Such portion would be subject to estate tax at the grantor’s death.  Any transfer tax would be paid by the trust.

The provision does not apply to (1) a trust for the exclusive purpose of paying deferred compensation under a non-qualified deferred compensation plan if the assets of the trust are available to satisfy the claims of the grantor and (2) typical life insurance trusts owning policies on the life of the grantor and/or the grantor’s spouse.

The Administration has included similar provisions in each of its Proposals for three consecutive years.  The change would apply to transactions entered into on or after the date of enactment.

The ability to benefit from the differences in the income tax and transfer tax rules applicable to irrevocable grantor trusts has existed (and survived) for decades.  Clients considering sales to grantor trusts may not want to delay them, however.

Modify GST Tax Treatment of Health and Education Exclusion Trusts (“HEETS”)

Payments (1) of tuition to a qualified education organization for education or training of a third party (i.e., child, grandchild or other person) and (2) to any person who provides medical care to a third party are excluded from taxable gifts.  Moreover, transfers which, if made during life, would be excluded under the gift tax rule are excluded from GST tax.  Taxpayers have taken the position (based on both the apparent intent and literal language of current law) that distributions from HEETS that are not otherwise exempt from GST tax to skip-persons (i.e., grandchildren and other persons assigned to a generation two or more generations below the transferor) for education and medical care are not subject to the GST tax.  The Administration is concerned that substantial amounts will be accumulated in HEETS and will not be subject to transfer tax for many generations.

This Proposal would modify current law to provide that only direct transfers by a taxpayer to either a qualified education organization or health care provider that qualify for gift tax exclusion would qualify for GST tax exclusion.  Disbursements from trusts for such purposes would not qualify for the GST tax exclusion.

The Administration has included similar provisions in its Proposals for two consecutive years.  The change would apply to trusts created after the introduction of the legislation and to additional transfers to existing trusts after such date.

Clients considering creating HEETS during their lives may not want to delay creating and funding them.

Simplify Gift Tax Exclusion for Annual Gifts

Under current law, gifts of up to $14,000 annually to an unlimited number of individuals are excluded from the donor’s gifts.  The gifts, however, must be of present interests to qualify for the annual gift exclusion.  Most gifts to trusts are gifts of future interests because the enjoyment of the property by the beneficiaries is not immediate but deferred.  Transfers to trusts can qualify as present interest gifts if the beneficiary (or the beneficiary’s legal representative) has the right to withdraw the contribution from the trust, even if for only a limited period of time after which the right lapses, based on a nearly half-century old case.  Crummey v. Comm’r., 397 F.2d82 (9^th Cir. 1968).  Such temporary withdrawal rights are generally referred to as Crummey rights.

The Administration’s concern is that donors are able to qualify transfers to trusts as present interest gifts by giving Crummey rights to multiple discretionary beneficiaries some of whom are unlikely to ever receive a distribution from the trust (a technique that has been upheld by the courts over the years).  The Administration cites the cost to taxpayers and the IRS of establishing the efficacy of purported Crummey rights in gift tax audits as further justification for the change.

This Proposal would eliminate the present interest requirement for a new category of transfers that instead would qualify for an annual gift tax exclusion of up to $50,000 per donor.  The new category includes (1) transfers in trust (other than trusts described in §2642(c)(2); i.e., a trust solely for the benefit of one person during his or her life and which is included in the beneficiary’s gross estate at death), (2) transfers of interests in pass-through entities (e.g., partnerships and S Corporations), (3) transfers of interests subject to a prohibition on sale and (4) transfers of property that, without regard to withdrawal, put, or other such rights in the donee, cannot immediately be liquidated by the donee.  Gifts that fell within one of the categories would qualify for the new annual gift exclusion of up to $50,000 without regard to either (a) the existence of any withdrawal or put rights or (b) the number of beneficiaries of the trust or transferees possessing such rights.

Although the change would eliminate the present interest requirement, and, therefore, the need for Crummey rights in traditional irrevocable life insurance trusts and stop the abuse perceived by the Administration, it would seem to discriminate against individuals with more than three beneficiaries with Crummey withdrawal rights who are likely to receive distributions from the trust in the future, such as children.  An individual with four children, all of whom held Crummey rights in a trust, can exclude up to $56,000 (4 X $14,000) of transfers to the trust from his or her gifts annually under current law.

The provision is new this year.  The change would be effective for gifts made after the year of enactment.

Expand Applicability of Definition of Executor

Current law defines an “executor” for purposes of the estate tax to be a person who is appointed, qualified and acting as executor or administrator of the decedent’s estate or, if none, then a person in actual or constructive possession of any property of the decedent.  Because the definition is limited to estate tax, it does not grant authority to act in respect to other types of taxes.  This Proposal would grant an authorized party the power to act on behalf of the decedent in all tax matters.

The provision is new this year and would apply upon enactment, regardless of a decedent’s date of death.

The change would be helpful to our clients, although we rarely encounter circumstances in which the IRS takes the position that an executor does not have authority to act in respect to other types of taxes.