ESTATE PLANNING SYNOPSIS
1. Estate Planning
a. The level of sophistication of estate plans varies with the size and complexity of an individual’s estate. A carefully drafted Will or revocable inter vivos trust is the starting point for many estate plans.
b. The following relatively simple documents may be important in the event of disability or incapacity: the health care proxy appoints an agent to make medical decisions in the event of incapacity. The living will states whether or not extraordinary means are to be used to keep one alive. The durable power of attorney, for financial transactions, survives incapacity, so that guardianship can be avoided. The durable power of attorney can be used to place assets into an existing inter vivos trust in the event of the incapacity of the grantor.
c. Everybody needs a will. A will tells the world exactly how you want your assets divided and where you want your assets distributed when you die. If you die without a will, the law will decide how your assets should be distributed. This is not the main reason to draft a will, as your assets will be divided amongst your immediate family according to intestate law. However, the law does not take into consideration the tax savings elements that a will can accomplish.
i. Federal Estate Tax. If you plan carefully, you can substantially reduce if not eliminate estate taxes. Both the estate tax and family estate planning objectives of the decedent can be accomplished with a will.
ii. Old Wills. Your existing Will should be reviewed to determine whether it accurately reflects your present testamentary objectives.
iii. Exemption amount increased to $3.5 million. In 2009, the federal estate tax exemption amount will be increase to $3.5 million. In 2010, the estate tax will be eliminated for that year. Obama has said that he will most likely freeze the estate tax at $3.5 million. The exemption amount was at $600,000 not too long ago.
(1) Many wills drafted prior to EGTRRA employ “formula” clauses eliminating estate tax on the death of the first spouse by creating a “credit shelter” trust funded with assets equal to the unused applicable exclusion amount (AEA), and then distributing the remainder of the residuary estate to the surviving spouse outright or in a marital deduction trust, such as a QTIP. The combination of the unified credit and marital deduction result in no tax at the first death. Anyone, including the surviving spouse, may be a beneficiary of the credit shelter trust, but to qualify for the QTIP marital deduction, only the surviving spouse may possess rights to income or principal. In fact, the surviving spouse must alone have the right to receive all income from the QTIP trust, paid at least annually, and no other person may be a beneficiary of that trust during the surviving spouse’s life. With the AEA reaching new levels far exceeding previous amounts, and with New York, retaining lower threshold levels for the imposition of estate tax, older formula clauses may produce unintended results. The danger exists that by funding the nonmarital (credit shelter) trust with the maximum amount that can be shielded by the AEA, the surviving spouse might be unintentionally disinherited. Particularly in cases where the estate is less than $4 million and the surviving spouse is not granted distribution rights to the nonmarital trust, consideration should be given to capping the formula clause allocation to the nonmarital trust at a level substantially below the AEA, perhaps at an amount no greater than the amount that can pass free of New York estate tax.
(2) Nevertheless, by capping the nonmarital share and increasing the marital share, a new problem arises: The estate of the surviving spouse might become subject to estate taxes. Fortunately, this problem can be avoided by funding a second nonmarital trust with the excess of the applicable exclusion amount over the cap placed on the first nonmarital trust. The surviving spouse could even be the sole beneficiary of this trust, the assets of which would remain outside of her taxable estate since no QTIP election will have been made. To illustrate, assume decedent dies in 2009 with a taxable estate of $5 million at a time when the AEA is $3.5 million. Nonmarital Trust #1 is funded with $1 million, the maximum amount that can pass free of New York estate tax. Nonmarital Trust #2 with $2.5 million, and the QTIP Trust with $1.5 million. Nonmarital Trust #1 and Nonmarital Trust #2 make full use of the AEA. The surviving spouse is granted the same distribution rights to Nonmarital Trust #2 as she is to the QTIP. Nonmarital Trust #2 will not, however, be included in her taxable estate because no QTIP election will have been made.
(3) Now consider New York estate tax consequences: New York’s applicable exclusion amount is $1 million, frozen at pre-EGTRRA levels. Nonmarital Trust #1 therefore makes full use of New York’s excludible amount. Does this mean that Nonmarital Trust #2 will attract New York estate tax? Not necessarily. Even though no federal QTIP election will be made for Nonmarital Trust #2, since New York has “decoupled” its estate tax from the federal estate tax regime, that trust might still qualify for the unlimited marital deduction for New York state estate tax purposes. If this strategy succeeds, Nonmarital Trust #2 would be includible in the surviving spouse’s estate for New York, but not for federal, estate tax purposes.
(4) This plan would (i) eliminate New York (and federal) estate tax completely on the death of the first spouse without overfunding the federal QTIP which will be subject to federal estate tax at the death of the surviving spouse; while (ii) providing maximum benefits to the surviving spouse. Even if no New York marital deduction is allowed for estate tax purposes, the assets in Nonmarital Trust #2 — a trust over which the surviving spouse will have substantial rights — will not be included in her federal taxable estate, because no QTIP election will have been made with respect to it.
iv. Unlimited Marital Deduction
(1) In general, the U.S. gift tax and estate tax laws permit unlimited tax-free transfers of property between spouses if the transferee spouse (i.e., the spouse receiving property) is a U.S. citizen. This “marital deduction” often is said to reflect the view that a husband and wife represent a single economic unit, and only transfers from that unit to third parties (e.g., children) should be subject to gift and estate tax.
(2) At death, if the surviving spouse is not a U.S. citizen, the transfer will not qualify for the unlimited marital deduction unless it passes to a qualified domestic trust. Thus, when one or both spouses in a married couple are not U.S. citizens, special planning may be required to avoid adverse tax consequences for transfers during lifetime or at death. Although widely criticized, this rule is based on a concern that the non-citizen spouse might move to another country and thereafter transfer property he or she received tax-free without being subject to U.S. gift and estate taxes.
(3) You may leave an unlimited amount of money to your spouse tax-free, but this is not always the best tactic. By leaving all your assets to your spouse, you don’t make use of your estate tax exemption. Instead, the size of your surviving spouse’s estate is increased and when the surviving spouse dies, your children are likely to pay more in estate taxes.
(a) HYPO: A husband and wife owning less than $7 million in assets will not pay estate taxes as they can both make use of their $3.5 million exemption amounts.
(b) Yes, you can leave everything to your spouse and not pay any tax but one has to take into consideration what happens when the second spouse dies.
(4) 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.
v. Avoidance of estate tax in the surviving spouse’s estate is also important. The decedent’s Will may direct that the proceeds of his policy be held in trust, with the surviving spouse allowed an income interest in trust assets. If a QTIP election were made by the decedent’s executor, or if the surviving spouse were granted either a power to invade the corpus of the trust or a general power of appointment, inclusion in her estate would be unavoidable. Conversely, if no marital deduction were claimed by the estate of the decedent, and the surviving spouse’s right to invade the trust corpus were limited by an “ascertainable standard” for her health, education, support, or maintenance, inclusion in her estate could be avoided. Moreover, the surviving spouse could be given a noncumulative yearly right to withdraw the greater of 5 percent of the balance of the proceeds, or $5,000, without risking inclusion in her estate.
vi. Alternatives to a Will: Wills eventually become public after your death:
(1) Revocable living trusts. Trusts will not save you anything in estate taxes. Trusts are used to avoid probate.
(2) Gifting assets before your death. $1,000,000
(3) Joint tenancy. Joint tenancy is a method of holding title to property when two or more persons own property together, but the final survivor will be wind up with the entire property.
2. Comparison: Will or Trust
a. Transfer of assets
i. Will: No transfer of assets required
ii. Trust: Extensive transfers required
i. Will: None
ii. Trust: Extensive maintenance; all activities must be conducted in name of trust
c. Planning for Disability
i. Will: Offers little; however, can be used in conjunction with Durable Power of attorney
ii. Trust: Offers considerable flexibility; a living trust can be established with a co-trustee assuming primary responsibility for the management of assets.
d. Present Costs
i. Will: Drafting of Will
ii. Trust: Drafting of Trust, transfer of assets into trust
e. Need for other Legal Documents
i. Will: Generally, trust not necessary
ii. Trust: Pour-over will necessary
i. Will: Probate is public
(1) In Terrorem clause probably ineffective
ii. Trust: Although higher degree of confidentiality, trust document could nevertheless become public
g. Legal Fees at Death
i. Will: Probate Fees
(1) Nonprobate assets include:
(a) jointly held home
(b) insurance with designated beneficiaries
ii. Trust: Administration Fees
h. Administration of Estate
i. Will: Probate can be time consuming
ii. Trust: Estate can be administered more quickly
i. Will Contests
i. Wills: Will can be challenged
ii. Trusts: Can also be challenged, but since in existence before death, less of a likelihood that it will be challenged.
(1) Trust may require greater mental facilities
(2) In that respect, may be easier to upset trust.
j. Governmental Assistance
i. Will: Can create testamentary trust which gives spouse benefit of assets while still qualifying for government assistance
ii. Trust: Testamentary trusts created by revocable trusts will not be excluded for purposes of determining eligibility for governmental assistance.
3. Annual Gift Tax Exclusion
a. In 2009, you may give up to $13,000 a year to an individual (or $26,000 if you’re married). You may also pay an unlimited amount of medical and education bills for someone if you pay these expenses directly to the institutions where they were incurred. You do not need to file a gift tax return for these gifts.
4. LLCs for Estate Planning
a. To accomplish the objectives of wealth transfer, business succession, and asset protection, the LLC has emerged as the clear entity of choice. The LLC can be used to shift income to lower bracket taxpayers, to shift wealth while leveraging the unified credit, and to effectively protect assets from claims of creditors. Favorable basis rules make the LLC an extremely attractive vehicle for real estate. The LLC operating agreement can provide for succession of a family business after the death of a member.
b. Installment sales of assets to grantor trusts indirectly exploit income tax provisions enacted to prevent income shifting at a time when trust income tax rates were much lower than individual tax rates. Specifically, the technique capitalizes on different definitions of “transfer” for transfer tax and grantor trust income tax purposes. The resulting trusts are termed “defective” because the different definitions of “transfer” result in a serendipitous divergence in income and transfer tax treatment when assets are sold by the grantor to his own grantor trust.
c. Overview of Asset Sale. For income tax purposes, after an asset sale has occurred, the grantor trust holds property on which the grantor continues to report income tax. However, the grantor is no longer considered as owning the asset for transfer tax purposes, and the trust assets, as well as the appreciation thereon, will be outside of the grantor’s taxable estate. As a result of this odd juxtaposition of income and transfer tax rules, the grantor is taxed on trust income but will have depleted his estate of the value of the assets for transfer tax purposes.
i. To illustrate the mechanics, assume the grantor sells property worth $5 million to a trust in exchange for a $5 million promissory note, the terms of which provide for adequate interest payable over 20 years, and one balloon payment of principal after 20 years. If the trust is drafted so that the grantor retains certain powers, income will continue to be taxed to the grantor, even though for transfer tax purposes the grantor will be considered to have parted with the property. This may over time reduce transfer taxes since the grantor is in effect making a tax-free gift to trust beneficiaries of money needed to pay the income tax liability of the trust. Assume that the grantor has sold a family business worth $5 million to the trust, and that each year the business is expected to generate approximately $100,000 in profit. Assume further that the trust is the owner of the business for transfer tax purposes. With the grantor trust in place, the grantor will pay income tax on the $100,000 of yearly income earned by the business. If the business had instead been given outright to the children, they would have been required to pay income taxes on the profits of the business.
d. The result of the sale to the defective grantor trust (“IDT” or “trust”) is that the income tax liability of the profits generated by the business remains the legal responsibility of the grantor, while at the same time the grantor has parted with ownership of the business for transfer tax purposes. A “freeze” of the estate tax value has been achieved, since future appreciation in the business will be outside of the grantor’s taxable estate. Nonetheless, the grantor will remain liable for the income tax liabilities of the business, and no distributions will be required from the trust to pay income taxes on business profits. This will result in accelerated growth of trust assets.
i. Achieving grantor trust status requires careful drafting of the trust agreement so that certain powers are retained by the grantor. For as long as grantor trust status continues, trust income is taxed to the grantor. A corollary of the grantor trust rules would logically provide that no taxable event occurs on the sale of assets to the grantor trust because the grantor has presumably made a sale to himself of trust assets. Basically, the grantor can sell appreciated assets to the grantor trust, effect a complete transfer and freeze for estate tax purposes, and yet trigger no capital gains tax on the transfer of the appreciated business into the trust.
e. The Note. Consideration received by the grantor in exchange for assets sold to the IDT may be either cash or a note. If a business is sold to the trust, it is unlikely that the business would have sufficient liquid assets to satisfy the sales price. Furthermore, paying cash would tend to defeat the purpose of the trust, which is to reduce the size of the grantor’s estate. Therefore, the most practical consideration would be a promissory note payable over a fairly long term, perhaps 20 years, with interest-only payments in the early years, and a balloon payment of principal at the end. This arrangement would also minimize the value of the business that “leaks” back into the grantor’s estate. For business reasons, and also to underscore the bona fides of the arrangement, the grantor could require the trust to secure the promissory note by pledging the trust assets.
i. The note issued in exchange for the assets must bear interest at a rate determined under § 7872, which references the applicable federal rate (AFR) under §1274. In contrast, a qualified annuity interest such as a GRAT must bear interest at a rate equal to 120 percent of the AFR. A consequence of this disparity is that property transferred to a GRAT must appreciate at a greater rate than property held by an IDT to achieve comparable transfer tax savings. As with a GRAT, if the assets fail to appreciate at the rate provided for in the note, the IDT would be required to “subsidize” payments by invading the principal of the trust. While no taxable event occurs when the grantor sells assets to the IDT in exchange for the note, if grantor trust status were to terminate during the term of the note, the trust would no longer be taxed as a grantor trust. This would result in the immediate gain recognition to the grantor, who would be required to pay tax on the unrealized appreciation of the assets previously sold to the trust.
f. Consequences of Transferred Basis. Note that for purposes of calculating realized gain, the trust will be required substitute the grantor’s basis: Even though the assets were “purchased” by the trust, no cost basis under § 1012 is allowed since no gain will have been recognized by the IDT in the earlier asset sale. Another situation where gain will be triggered is where the trust sells appreciated trust assets to an outsider. One way of mitigating this possibility would be for the grantor to avoid initially selling appreciated assets to the trust. If this is not possible, the grantor could also substitute higher basis assets of equal value during the term of the trust, as discussed below.
i. Care should be exercised in selling highly appreciated assets to the grantor trust for another reason as well: if the grantor were to die during the trust term, the note would be included in the grantor’s estate at fair market value. However, the assets which were sold to the trust would not receive the benefit of a step-up in basis pursuant to § 1014(a). Any gift tax savings occasioned by the transfer of assets could be negated by the failure of the trust to receive an increase in basis. To avoid this result, the trust might either (i) authorize the grantor to substitute higher basis assets of equal value during his lifetime; or (ii) make payments on the note with appreciated assets. [Note that if the grantor received appreciated assets in payment of the note, those assets would be included in the grantor’s estate, if not disposed of earlier. However, they would at least be entitled to a step-up in basis in the grantor’s estate pursuant to § 1014.]
g. As noted above, since the assets are being transferred to the grantor trust in a bona fide sale, those assets should be excluded from the grantor’s taxable estate. However, since the grantor is receiving a promissory note in exchange for the assets, the IRS could take the position that under § 2036, the grantor has retained an interest in the assets which require inclusion of those assets in the grantor’s estate.7 In order to minimize the chance of the IRS successfully invoking this argument, the trust should be funded in advance with assets worth at least 10 percent as much as the assets which are to be sold to the IDT in exchange for the promissory note.
i. In meeting the 10 percent threshold, the grantor himself should make a gift of these assets so that after the sale in exchange for the promissory note, the grantor will be treated as the owner of all trust assets.
h. Choice of Trustee. Trustee designations should also be considered: Ideally, the grantor should not be the trustee of an IDT, as this would risk inclusion in the grantor’s estate, especially if the grantor could make discretionary distributions to himself. If discretion to make distributions to the grantor is vested in a trustee other than the grantor, then the risk of adverse estate tax consequences is reduced. The risk is reduced still further if the grantor is given no right to receive even discretionary distributions from the trust. If the grantor insists on being the trustee of the IDT, then the grantor’s powers should be limited to administrative powers, such as the power to allocate receipts and disbursements between income and principal. The grantor may also retain the power to distribute income or principal to trust beneficiaries, provided the power is limited by a definite external standard.
i. The grantor as trustee should not retain the right to use trust assets to satisfy his legal support obligations, as this would result in inclusion under §2036. However, if the power to satisfy the grantor’s support obligations with trust assets is within the discretion of an independent trustee, inclusion in the grantor’s estate should not result. However, if the grantor retains the right to replace the trustee, then the trustee is likely not independent, and inclusion would probably result. Note that despite the numerous prohibitions against the grantor being named trustee, the grantor’s spouse may be named a beneficiary or trustee of the trust without risking inclusion in the grantor’s estate.
i. Death of Grantor. The following events occur upon the death of the grantor: (i) the IDT loses its grantor trust status; and (ii) presumably, assets in the IDT would be treated as passing from the grantor to the (now irrevocable) trust without a sale, in much the same fashion that assets pass from a revocable living trust to beneficiaries. For reasons similar to those discussed above with respect to sales of appreciated trust assets, the basis of trust assets would not be stepped-up pursuant to §1014(a) on the death of the grantor, because the assets will not be included in the grantor’s estate. This is in sharp contrast to the situation obtaining with a GRAT, where the death of the grantor prior to the expiration of the trust term results in the entire amount of the appreciated trust assets being included in the grantor’s estate.
i. Tax consequences of the unpaid balance of the note must also be considered when the grantor dies. Since the asset sale is ignored for income tax purposes, the balance due on the note would not constitute income in respect of a decedent.. The remaining balance of the note would however be included in the grantor’s estate and would acquire a basis equal to the value included in the estate.
j. LLC Combined With IDT Asset Sale. By combining the LLC form with asset sales to grantor trusts, it may be possible to achieve even more significant estate and income tax savings. LLC membership interests are entitled to minority discounts since the interests are subject to significant restrictions on transfer and management rights. If the value of the LLC membership interest transferred to the IDT is discounted for lack of marketability and lack of control, the value of that interest will be less than a proportionate part of the underlying assets. Consequently, in the case of an asset sale to the IDT, the sale price will be less than if the assets had been directly sold to the IDT.
i. To illustrate, assume the following events: (1) parent transfers real estate worth $1 million to a newly formed LLC of which parent is the Manager; (2) parent gives 10 percent membership interests to each of two children; (3) parent gives a 10 percent membership interest to a newly-formed grantor trust; and after a reasonable period of time (4) parent sells a 50 percent membership interest in the LLC to the grantor trust for fair market value. After the dust settles, parent will own a 20 percent interest in the LLC outright, the children will each will own a 10 percent interest, and the trust will own a 50 percent interest in the LLC.
(1) In determining the FMV of the LLC interest sold to the trust, parent engages the services of a professional valuation discount appraiser and a real estate appraiser. It is determined that the value of the real estate is to be discounted by 50 percent after application of the lack of control and lack of marketability discounts. Therefore, the 50 percent membership interest is sold to the trust for $250,000 (i.e., $500,000 x .5). Parent agrees to accept a promissory note bearing interest at the rate of 6 percent, pursuant to § 1274, or $15,000 per year, with a balloon payment of principal at the end of the promissory note’s 15-year term.
(2) If the underlying business appreciates at a yearly rate of 10 percent, the value of the underlying assets purchased by the trust in exchange for the promissory note would increase by $50,000 in the first year (i.e., $500,000 x .10). Had the LLC membership interests not been discounted, the real estate would have commanded a purchase price by the IDT of $500,000, and the required yearly interest payments would have instead been $60,000 (i.e., $500,000 x .06). By discounting the property purchased by the IDT to reflect minority discounts, the required interest payments to parent have been reduced from $30,000 to $15,000. If the underlying assets grow at a rate of 10 percent, then 70 percent of the growth (i.e., $35,000/$50,000) can remain in the trust. It is apparent that more value can be transferred to family members if the property purchased by IDT in exchange for the promissory note can be discounted.
(3) The LLC asset sale to the IDT would result in the following favorable tax and economic consequences: (i) $500,000 would be transferred out of the grantor’s estate for estate tax purposes; (ii) future appreciation on the $500,000 would be transferred permanently out of the estate; (iii) unlike the situation obtaining with a GRAT, the results in (i) and (ii) would not depend on the grantor surviving the trust term; (iv) since the promissory note could bear a lower rate of interest, fewer funds would be brought back into the grantor’s estate, resulting in a more perfect “freeze” for estate tax purposes; and (v) since the LLC assets are discounted, the purchase price by the trust would reflect that discount, making the effective yield of assets within the LLC even higher.
5. New York State Estate Tax
a. New York continues to impose an estate tax on estates over $1 million. Before EGTRRA, New York imposed a “pick up” estate tax on the maximum credit for state death tax allowed by IRC § 2011. However, EGTRRA has eliminated that credit in phases. Rather than lose estate tax revenue, some states, including New York have “decoupled” their tax codes from the federal code. New York has accomplished this objective by remaining linked to federal law as it existed before EGTRRA.
b. Under pre-EGTRRA law, no federal estate tax would be imposed on an estate of $1 million. Since there would be no federal tax, New York would have nothing to “pick up”. However, a taxable estate of $1,093,755 would now incur tax of $38,452, which is 41% of the amount in excess of $1 million. If the taxable estate were greater than $1,093,755, the same $38,452 would be paid on the first $93,755 in excess of $1 million, but amounts in excess of $1,093,755 would be subject to tax at rates beginning at 6% and rising, for very large estates, to 16%.
6. Trusts and Prenuptial Agreements
a. The prenuptial agreement effectively protects against the vagaries of marital dissolution. However, even a well-drafted prenuptial agreement will not always succeed in fully accomplishing this objective. For example, the agreement will likely not prevent separate property from becoming marital property if assets are commingled. Nor is there any assurance that a prenuptial agreement will not be declared invalid in whole or in part if circumstances have changed during a long marriage, or if the equities of the case run against the party in whose favor enforcement of the prenuptial agreement would inure. Fortunately, the prenuptial agreement need not stand alone: Inherited family wealth and to a lesser extent assets acquired before marriage may be protected by a trust.
b. Typically, a trust designed to protect family wealth would be created by a parent for the benefit of the either spouse. Unlike a prenup, the trust could be implemented at any time, even after marriage, and could exist without the knowledge other spouse. Trust distributions could be within the unreviewable discretion of the trustee, who might be the parent implementing the trust. Generally, inherited property, even that acquired during marriage, remains separate property.
c. During the pendency of a divorce proceeding, the trustee could cease making distributions. Since the beneficiary could not force the trustee to make a distribution during the divorce, a fortiori the creditor-spouse could not. A creditor’s rights cannot exceed those of the debtor. (However, an exception might exist for court-ordered child support or alimony payments. A court might invade even a discretionary trust to satisfy these obligations.)
d. Where a spouse has herself accumulated significant wealth before marriage, asset protection need also not stop with the prenup. Although NY EPTL § 7-3.1 has long provided that trusts created by the grantor for her own benefit which purport to shield trust assets from creditors are unenforceable, not all domestic jurisdictions continue to adhere to this common law view.
e. A decade ago, one attempting to circumvent the EPTL prohibition against “self-settled” spendthrift trusts might have ventured to a remote venue with a tropical — or vaguely sinister — name. Today, one need venture no further than Delaware. This does not mean that a New York court would not look askance upon such a trust. Nonetheless, a New York court seeking to invade the trust might find it difficult to convince a Delaware court in whose jurisdiction the assets reside of the inapplicability of the Full Faith and Credit Clause.
7. Step up in basis rules changed in 2010. New basis rules to take effect in 2010 eliminate basis step-up in favor of a transferred basis regime. However, a $3 million basis increase will be allowed for property passing to a surviving spouse outright or in a QTIP trust; and a $1.3 million basis increase will be allowed for assets passing to any beneficiary, including the surviving spouse. Once these two permitted basis increases are exhausted, beneficiaries will receive assets without any basis increase. To avoid conflict among beneficiaries, the will could provide that assets should be allocated to the nonmarital share in a manner fairly reflecting the appreciation and depreciation in all assets available for allocation.
a. Step up in basis- What is the rule now? Why may not always be beneficial to put house in children’s name
8. Like-Kind Exchanges
a. Like-kind exchanges are an excellent estate planning, tool since at your death the property will receive a step-up in basis to fair market value. Therefore, you could either continue to depreciate the property, or sell it without incurring any capital gains tax.
b. IRC § 1031 provides for nonrecognition of gain or loss realized in a “like-kind” exchange of property held for productive use in a trade or business or for investment, provided the replacement property is held for the same purpose. The rationale for this venerated tax rule is that the new investment is merely a continuation of the old investment in another form. Through basis adjustments, the gain or loss is deferred until the property is liquidated. Instead of a cost basis, the transferor will take an exchanged basis. This substituted basis, depending on the circumstances, may not be favorable: For example, if appreciated real estate which has been fully depreciated is exchanged for new real estate, no depreciation deductions will be allowed with respect to the replacement property. If replacement property is worth more than exchanged property, additional consideration will be required to close. This nonqualifying property or “boot” (e.g., cash, unlike property, debt relief), will not cause the §1031 transaction to fail. Instead, realized gain will be recognized to the extent of this boot; the balance of realized gain will be deferred. (If the installment sales rules apply, boot gain may itself be deferred under § 453.) Deferred exchanges may not be deferred beyond statutorily imposed dates. Thus, § 1031(a)(3) provides that replacement property must be identified within 45 days after the taxpayer transfers the relinquished property, and must be exchanged within 180 days thereafter, or by the due date of the taxpayer’s tax return (including extensions) for the tax year in which the transfer occurs, if earlier. Failure to meet either requirement results in a taxable sale.
i. Although its requirements are technical, §1031 is not elective. Consequently, the nonrecognition of losses in an exchange that appears at first blush to require nonrecognition treatment may be undesirable, and could pose a trap for the unwary. However, by intentionally failing to comply with the statute’s technical rules, loss recognition should result. The Tax Court would likely be constrained to rule against the IRS if §1031 were not satisfied by reason of the replacement property not having been timely identified. Nevertheless, the taxpayer seeking to report losses should consider violating more than one statutory requirement, if possible. To defeat an IRS assertion that substance over form compels nonrecognition of losses, the taxpayer might gain advantage by violating both the continuity requirement (e.g., by deeding the property into a new entity immediately after the exchange) and the identification and exchange requirements.
ii. What exactly constitutes “like-kind” property? Reg. §1.1031(a)-1(b) instructs that the term refers to the “nature or character of the property and not to its grade or quality within a class.” Real property exchanges have flourished because unimproved and improved real estate are considered to be of “like-kind,” provided the exchange involves the exchange of fee interests. (For this purpose, a leasehold interest of 30 or more years is identical to a fee interest.) Thus, real estate in the city for a farm or ranch qualifies (Reg. §1.1031(a)-1(c)), as does an apartment for vacant land plus golf course improvements (PLR 9428007). Personal property, in contrast, must be nearly identical to qualify as like-kind. For example, a truck and an automobile are not like-kind, nor are bullion-type coins and numismatic coins, livestock of opposite sexes, a copyright on a song and a copyright on a novel, or even an antique desk and antique chair. Examples of personalty which meet the stringent definition include copyrights of novels, livestock of the same sex, antique automobiles, and baseball player contracts.
(1) To illustrate the statute, assume M, Manhattanite, wishes to exchange commercial real estate in Manhattan for commercial property in Hilton Head. Assume further that it would be difficult for M to locate an owner of commercial property in Hilton Head willing to swap island property with M in a direct exchange. L, Long Islander (who is himself indifferent to § 1031 treatment), has offered to buy M’s Manhattan property. One option would be for M to prevail upon L to purchase the Hilton Head property, and then engage in a like-kind exchange with L. In practice, L would likely be unwilling to purchase the Hilton Head property simply to accommodate M’s desire to acquire the Hilton Head property in a § 1031 exchange.
(2) To facilitate an exchange in the event M cannot prevail upon L to purchase the Carolina property M may, pursuant to an agreement, transfer the property to an intermediary who (i) sells the property to L, (ii) purchases suitable exchange property in Hilton Head with the proceeds, and then (iii) transfers title in the newly purchased Hilton Head property back to M. For this “multiparty” deferred exchange to qualify under §1031, there must be no actual or constructive receipt of money or other property by M before the Hilton Head property is received. Otherwise, the transaction will be taxed as a sale.
iii. Treas. Reg. §1.1031(k)-1 provides four safe harbors (which clarify and expand on decisional law) in structuring multiparty deferred exchange agreements which avoid actual or constructive receipt. The theme of each safe harbor is to preclude the transferor from receiving, pledging, borrowing or otherwise obtaining the benefits of money or other property before the end of the exchange period (except if no replacement property has been timely identified, in which case these rights may be invested in the transferor after the (lapsed) identification period, since §1031 would not apply.) If replacement property is timely identified, the transferor may then possess rights to receive, pledge, or borrow money upon the receipt of the replacement property, or even earlier, i.e., upon the occurrence of a written contingency that relates to the deferred exchange and is beyond the control of the transferor or other “disqualified persons,” excluding however the person obligated to transfer the replacement property. [Reg. §1.1031(k) defines “disqualified person” as a person who, within the 2-year period ending on the date of transfer of the relinquished property, acts as the taxpayer’s agent, employee, attorney, accountant, investment banker, broker or real estate agent.]
(1) The first safe harbor provides that the transferor does not have actual or constructive receipt of money or other property before receipt of replacement property solely because the obligation of the other party to the transaction is or may be secured or guaranteed by (i) a mortgage, deed of trust or other security interest in property; (ii) a standby letter of credit (LC) that the transferor cannot draw upon except on default, or (iii) a guarantee of a third party. To revisit the previous illustration, L, desirous of the Manhattan property, agrees to purchase the Hilton Head property and then exchange it for the Manhattan property owned by M. Prior to transferring title to the Manhattan property, L is required to furnish a standby nonnegotiable and nontransferable LC which M may draw upon only in the event L does not deliver the Hilton Head property within 180 days after M relinquishes title to the Manhattan property. The LC satisfies the safe harbor rule and, assuming L delivers the Hilton Head property in a timely fashion, the transaction constitutes a like-kind exchange within respect to M.
(2) The second safe harbor, similar to the first, relates to “qualified” escrow accounts, and provides that a transferor does not have actual or constructive receipt of money before the receipt of replacement property merely because the obligation of the other party to the transaction is or may be secured by cash or a cash equivalent held in a “qualified” escrow account. A qualified escrow account is one in which (i) neither the transferor nor other disqualified person is the escrow holder or trustee, and (ii) the escrow or trust agreement limits the transferor’s right to receive, pledge or borrow funds held in the escrow account or by the trustee.
(3) The third safe harbor explores the concept of qualified intermediary (recall the potential reluctance of L to purchase the Hilton Head property), and imposes three requirements to avoid constructive receipt: First, the intermediary can be neither the transferor nor the transferor’s agent, nor any person related to the transferor after application of the attribution rules found in §267(b) or §707(b); second, the agreement between the transferor and intermediary must expressly limit the former’s right to receive, pledge or borrow cash or property held by the intermediary; and third, the written agreement must obligate the intermediary to (i) acquire the relinquished property from the transferor; (ii) transfer the relinquished property to the transferee; (iii) acquire the replacement property; and (iv) transfer the replacement property to the transferor.
iv. As alluded to earlier, the installment sales rules under § 453 will not necessarily hinder the application of §1031. Under those rules, the direct or indirect receipt of cash or cash equivalents is treated as receipt of payment. Reg. §1.1031(k) provides that a transferor is not deemed to have received an installment payment under a qualified escrow account or qualified trust arrangement, nor is the receipt of cash held in an escrow account by a qualified intermediary treated as a payment to the transferor under the rules, provided the transferor has a bona fide intent to enter into a deferred exchange at the beginning of the exchange period.
v. The taxpayer holding real property may wish to exchange that property in a like-kind exchange and thereafter transfer the exchanged property into a corporation or LLC. Careful attention must be paid to the statute’s requirement of a continuation of business investment. Rev. Rul. 75-292 1975-2 opined that replacement property contributed to a corporation shortly after an exchange violates the requirement of continuity of investment and results in gain. The Tax Court however (Magneson, 81 TC 782, aff’d CA-9, 753 F2d 1490), distinguished this ruling and allowed an immediate contribution of property to a partnership. The taxpayer might permit the §1031 exchange to “age” before engaging in the contemplated transfer.
9. Qualified Personal Residence Trust
a. A QPRT is a powerful gifting tool that leverages the gift tax credit and freezes the appreciating residence at its current value. The QPRT is an irrevocable trust that holds the residence for a terms of years. In essence, a QPRT is formed when a grantor transfers a personal residence into a residence trust, and retains the right to live in the residence for a term of years. If the grantor dies before the end of the trust term, the trust assets are returned to the grantor’s estate, and pass under the terms of the grantor’s will. However, if the grantor outlives the trust term, the residence passes to the named beneficiaries without any gift or estate tax event.
i. A longer trust term will increase the value of the reserved term and decrease the initial taxable gift.
ii. Any appreciation during the term of the trust would also have been diverted from the grantor’s estate.
10. Life Insurance Trusts
a. Life insurance proceeds are excludible from beneficiaries’ income under §101, provided the policy had not been transferred for valuable consideration. Proceeds from policies transferred in trust will also be excluded from the insured’s gross estate provided the insured (i) retained no incidents of ownership in the policy and (ii) survived three years after making the transfer. To ensure favorable estate tax consequences, the trust must also be both irrevocable and not amendable. It is therefore crucial that the insured understand the finality of decisions made when executing the trust.
b. Even though the policy in trust may be excluded from the gross estate, proceeds can nevertheless be used to satisfy estate tax liabilities. However, the trust agreement must not obligate the trustee to assist in the payment of estate taxes. Thus, even though a major objective of an irrevocable life insurance trust may be to satisfy estate tax liabilities, the trust language must not mandatorily direct such payments. Language appearing to require the trust to pay estate taxes could result in estate tax inclusion under §2042 — regardless of whether the proceeds are so used.
c. In order to accomplish the desired objective, the trust could authorize the trustee to purchase assets from, or make commercially reasonable loans to, the estate. Alternatively, the insurance proceeds might simply be distributable to beneficiaries who would ultimately bear the burden of estate taxes, as determined by the insured’s Will. The Will must be carefully coordinated with the Trust to accomplish that objective. Inconsistent language in the two instruments could result in harsh estate tax consequences.
d. Life insurance trusts are flexible post-mortem vehicles for distributing income and principal to beneficiaries: If broad discretionary powers are granted to the trustee, principal may be distributed estate tax-free to children either when they reach a particular age, or earlier, if the trustee is given such discretion. The trust may also permit “sprinkling” income distributions to the surviving spouse, who may or may not require trust income or principal.
e. To ameliorate the harsh estate tax consequences occasioned by the application the three-year inclusion rule, the trust might might direct that in such event insurance proceeds instead be payable to the insured’s estate. While this would negate provisions benefiting children, it would allow the Will (if so drafted) to claim a marital deduction which would at least keep the wolf at bay and result in exclusion from the gross estate.
f. Premiums paid by the insured may qualify as annual exclusion gifts under the Crummey doctrine. The IRS has attempted to defeat Crummey powers where a contingent beneficiary had “no interest other than the withdrawal power”. However, the Tax Court in Kohlsatt (T.C. Memo 1997-212) rejected that position where “credible” reasons were offered by trust beneficiaries not to exercise withdrawal rights. Where the Crummey withdrawal right exceeds $5,000, the use of a “hanging” power may avoid the lapse which would cause a gift back into the trust by the Crummey beneficiary.