Estate Planning in 2002 Requires Flexibility

With estate tax repeal scheduled to occur in 2010, but reinstatement to follow in 2011, estate planning documents must be sufficiently flexible to operate in either tax regime, or any other that Congress or a later administration determines. Wills and trusts must contemplate all possible scenarios.

Wills providing for a testamentary QTIP trust might provide for an alternate disposition into another trust for the spouse or heirs if estate tax has been repealed at the testator’s death. Both revocable and irrevocable trusts might be drafted to include a power vested in an independent trustee to change the terms of the trust while the grantor is alive to take into account the changes in the estate tax. The trustee of an irrevocable trust might be given authority to make greater distributions to the grantor. However, one must ensure that such greater powers do not cause trust assets to be included in the grantor’s estate under IRC § 2036.

Formula clauses for the marital deduction may require modification in light of pending estate tax changes. A “reduce-to-zero” pecuniary marital deduction bequest results in the marital deduction bequest being funded with the smallest amount necessary to reduce estate taxes to zero. As the exemption amount increases, the marital bequest decreases. Following repeal of the estate tax, the marital bequest would decrease to zero. This result will probably not accord with the testator’s wishes. Moreover, failing to include a marital bequest would leave the $3 million basis step-up available for property passing to a surviving spouse unutilized in the new carryover basis regime (see “From Washington”).

Since estate tax repeal ultimately might not occur, use of the $1 million gift tax exclusion may be prudent. Future appreciation will be shifted out of the estate. Use of a zeroed-out GRAT (example 5 of the Regs. which deterred its use was repudiated by the Tax Court in 2001) can result in large transfers utilizing only a tiny fraction of the $1 million gift tax exclusion. Although the retained annuity in a zeroed-out GRAT will be significant, estate tax rates will presumably be much lower (or nonexistent) when the grantor dies. GRATs in general also benefit from the favorable APR interest rate. The assumed rate of return need only exceed 120% of the APR for the GRAT to accomplish its objective. A decrease in the deemed rate of return requires a greater invasion of principal, reducing the remainder interest, and the initial taxable gift.

QPRTs, on the other hand, fare worse with a lower APR. A larger taxable gift is made at the outset since the amount needed to fund the annuity is smaller. This results in fewer assets being transferred out of the estate. Although a longer term QPRT may result in a sufficiently small taxable gift, the estate tax may be repealed prior to the expiration of the trust. Taxpayers may be unhappy if they survive the term of a QPRT only to find that the estate tax repeal was indeed permanent.

LLCs and partnerships retain their perennial allure by fractionalizing assets, thereby shrinking taxable gifts of interests in the entity. These entities also provide excellent asset protection. LLCs possessed of non-tax purposes stand to fare much better under IRS scrutiny.

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