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Does Income Ta Planning Now Trump Estate Ta Avoidance?

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For decades, estate planning has been dominated by a desire to avoid a confiscatory federal estate tax. In 1976, the amount a decedent could pass tax-free to non-charitable heirs was only $60,000. By the early 1980s it had increased to $175,000. These relatively small exemption amounts meant even middle class Americans had to design their estates to avoid the federal estate tax.

The Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”) effectively began to take the middle class out of the federal transfer tax system by the adoption of a series of reforms, including a $10,000 annual exclusion, an unlimited marital deduction and a phased-in unified tax credit equivalent to a $600,000 exemption. The Taxpayer Relief Act of 1997 provided for a phased-in increase in the exemption to $1 million by 2006. The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) provided for even higher tax-free transfers (e.g., $2 million beginning in 2006).

While permanent elimination of the federal estate tax is highly unlikely, significant estate tax exemptions will probably remain for the foreseeable future, reducing the tax confiscation many clients had anticipated at their death. It is generally expected that any tax bill in 2005 will provide for higher estate tax exemptions in lieu of an elimination of the estate tax.

These changes mean that fewer Americans than any time in recent history will be subject to a federal estate tax. By one estimate, in 2006, less than 1% of all decedent estates will owe a federal estate tax. For the vast majority of Americans, estate planning will no longer be driven by the avoidance of a federal transfer tax. Instead, personal and family concerns and other tax issues will drive the estate planning process.

In the years to come, avoidance of state and federal income taxes and state estate taxes will become the prime tax planning motivations.

Prior to EGTRRA, 38 states used the maximum federal state estate tax credit as their state estate tax. Effectively, these states took a portion of the federal estate tax using the federal credit. As a part of EGTRRA, Congress replaced the federal state death tax credit with a federal estate tax deduction. The elimination has resulted in states creating new state estate taxes that are “decoupled” from the federal estate tax. Even if Congress restored the federal state death credit, many states will be reluctant to reduce their tax revenue by adopting the higher federal exemptions.

The changes wrought by EGTRRA are creating significant changes in the state tax rules governing estates. Among the results of these changes are:

o Some states will adopt exemptions that are lower than the higher federal exemptions, creating a state estate tax when no federal estate tax is due.

o Some states will freeze their state death tax as the pre-2001 federal credit, resulting in a top effective state tax rate of 16% (i.e., the top rate for the old federal state death tax credit).

o Some states may adopt inheritance taxes, with the tax rate being determined by the relationship of the decedent to the heir (i.e., the more remote the heir, the higher the tax rate).

o Like the federal government did in 1924, more states will adopt a state gift tax to stop the loss of transfer tax revenue through lifetime gifts. As of Dec. 31, 2003, only Connecticut, Louisiana, North Carolina and Tennessee have a state gift tax.

o The lack of uniformity in state death taxes will add significant complexity to estate plans. For example, if a person owns property in more than one state, the avoidance of the cost and estate taxes of ancillary probate will become a greater part of the estate plan.

o The pressure to “forum shop” will increase as taxpayers attempt to move their tax domicile to states like Florida that have lower taxes. Florida cannot amend its state estate tax without a constitutional amendment (an unlikely event given the number of retirees in south Florida).

With a small number of Americans subject to a federal estate tax, more planners and clients will focus on saving income taxes. Among the income tax planning opportunities are:

==A client who is funding benefits or obligations (e.g., college or support costs) for someone (e.g., a college age child or a parent in a nursing home) who is in a lower income tax bracket should consider adopting approaches by which the ordinary income or capital gains of the client are shifted to the lower tax rate taxpayers. For example, assume a client has a rental property that produces ordinary taxable income of $100,000 per year. The client is in the 40% federal bracket, but his 5 children and 10 adult grandchildren are all in an effective tax bracket of 15%. The client places the rental property in an FLP and retains a 2% general partnership interest. Over a few years, he transfers the FLP interests to a spray trust for his descendants. The trust has the right to spray income among his descendants. Using the income tax brackets of the 15 trust beneficiaries, the overall annual tax on his rental property would drop by up to $24,500.

==When clients want to make charitable bequests, they should consider funding the charitable bequests with retirement or other assets that would have created “income in respect of a decedent.” For example, assume a client has a desire to pass $30,000 to a charity at the time of his death. He holds an IRA worth $25,000. The client could name the charity as beneficiary of his IRA and provide in his will that the estate pay to the charity the difference between $30,000 and the IRA value at his death. Assume the IRA was worth $20,000 at death and the client’s only heir is in a 40% state and federal income tax bracket. The passage of the $20,000 in IRA funds to charity would save the heir up to $8,000.

==Investments in trusts and estates may change to those that are more tax effective. Net after-tax returns will become a critical part of investment evaluations. This trend is already evident in the growth of total return trusts. One motivation for total return trusts is the desire to move away from strict definitions of income and principal that tend to distort fiduciary investment decisions.

==While basis issues always have been an aspect of global planning, the income tax benefit derived from basis planning often was eclipsed by the need to minimize a confiscatory federal transfer tax. With the transfer tax less of an issue for most Americans, the income tax planning benefits of planning for the basis of assets is receiving new attention. When an asset is includible in a taxable estate, the asset generally obtains a step-up in basis to the asset’s fair market value.

For years, much of the conflict between tax practitioners and the IRS has been over the “undervaluation” of assets on federal transfer tax returns. That world is getting ready to change. With the significant reductions in the number of taxable estates, the IRS and tax practitioners may be ready to change roles. When there is no federal estate tax due, practitioners will drive values up to obtain a greater step-up in basis, while the IRS will begin to challenge the higher values.

For example, assume that in 2006 (i.e., when the federal estate tax exemption is equal to $2 million) a terminally ill client owns 40% of a business worth $4 million. The estimated valuation adjustments are 30%. The client’s sole heir owns the remaining 60% of the business. The client’s remaining assets are $200,000. If the decedent dies without any changes, the step-up in the 40% business interest would be $1,120,000. Assume instead, the client purchases a 15% minority interest from the heir for a note for $420,000. At the client’s death, his 55% interest is worth at least $2.2 million. The note and remaining assets would produce a non-taxable estate of $1,980,000, while providing a step-up in basis for the 55% interest to $2.2 million. Assuming the heir sold the business after the client’s death, the new step-up in basis would save approximately $216,000 in capital gain taxes, assuming a 20% applicable rate.

==For years, clients and planners have used Income Defective Trusts to reduce a client’s federal estate taxes. An Income Defective Trust uses the differences in the income and grantor tax rules to create a trust that remains taxable to the donor for income tax purposes, while the trust assets are removed from the grantor’s taxable estate. However, with the recent increases in the federal estate tax exemptions, the gap between the income tax and transfer tax rules may create planning opportunities for Estate Defective Trusts. Such trusts are created purposely to have the trust income taxable to the trust or its beneficiaries, but to have the trust assets remain in the grantor’s taxable estate.

An Estate Defective Trust (“EDT”) has two principal income tax-related benefits. First, the tax on the income of an EDT is allocated to either the trust or its beneficiaries. The EDT can effectively permit a grantor to use the lower income tax brackets of the trust beneficiaries to reduce the overall income taxes of the family. Second, many clients hold low basis assets (e.g., a family farm or business). A client may want to gift the asset to family members, but does not want to lose the benefit of the step-up in basis which occurs at death. The client can place the asset in an EDT. Beneficiaries will receive the current income benefit of the asset, but the asset will remain part of the grantor’s taxable estate, permitting a step-up in basis.

Benjamin Franklin said that only taxes and death are inevitable. As long as we have taxes, tax avoidance will remain a major motivation for many clients. With federal death taxes no longer impacting the vast majority of Americans, the avoidance of state and federal income taxes and state estate taxes are becoming the prime tax avoidance motivation.

John J. Scroggin, J.D., LL.M., is an estate planning attorney in Roswell, Ga. And author of “The Family Incentive Trust,” published by The National Underwriter Company. He can be reached via e-mail at [email protected].