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JMBM Tax Newsletter: New Developments: Spreading the Wealth – The Future of Estate Planning and the Current Opportunities

Speculation runs rampant about the income, gift and estate tax changes that will result from the administration of President-Elect Obama. Most of the recent discussion has focused on tax rates applicable to ordinary income, capital gains, and dividends. Gift and estate tax changes, which affect most of readers of this newsletter, have received much less attention. However, change is certain and extraordinary opportunities exist today and, hopefully, in the first few months of 2009 to take advantage of current law.

Some estate and gift tax changes are certain. Under the 2001 Tax Act, the gift tax exemption has remained constant over the last several years at $1 million. The estate tax exemption has steadily risen to $2 million and is scheduled to increase to $3.5 million in 2009. For persons dying in 2010, current law provides for repeal of the estate tax, with reinstatement at 2001 levels for estates of decedents dying in 2011. It has been widely accepted that this will not happen. Both presidential candidates supported the position that the 2009 exemption of $3.5 million per person ($7 million for a married couple) be made permanent. They both also advocated the concept of “portability” so that any unused exemption of one spouse could be easily used by the other spouse. They differed sharply on rates, with President-Elect Obama supporting the current 45% rate becoming permanent.

What has not been discussed recently are additional means by which substantial gift and estate tax revenue could be raised by curtailing some of the planning techniques used to minimize taxes for estates larger than the exemption amounts. The balance of this article focuses on these possible “estate tax casualties” and also the current opportunities presented from a “perfect storm” of economic factors that make the use of many of these techniques compelling, whether or not they are repealed in the next Congress.

Why is this the perfect time to do significant wealth transfer planning? It results from the coincidence of three economic factors: (1) historically low interest rates; (2) depressed values in many asset classes; and (3) increasing valuation discounts based on market volatility. Many traditional estate tax techniques employ these factors to facilitate the transfer of future valuation increases to heirs with little or no gift or estate tax consequences. Consider a Grantor Retained Annuity Trust (GRAT), for example. The Internal Revenue Code expressly allows a person to transfer assets to a Trust in exchange for payment from the Trust of an annuity (a yearly amount), that includes an interest factor set by the IRS, called the Section 7520 rate (currently 3.6%). The annuity payment could be set so that the grantor receives total payments during the term of the GRAT (two years or more) equal to the value of assets contributed to the Trust. If so, there is no gift. If the value of the GRAT assets increase more than 3.6% per year, the entire excess passes to or in continuing trust for the grantor’s children. This has been a favorite wealth transfer technique of the rich and famous, including the Gates, Buffet and Walton families, and numerous Google millionaires.

GRATs work for many different asset types including marketable securities, family businesses, real estate and family investment partnerships. The value of many of these assets is at five to ten year lows today. The IRS implied interest rate of 3.6% is among the lowest in the last several years. In addition, if the assets are held in an entity such as a partnership, LLC or corporation, traditionally accepted valuation principles permit an interest in the entity holding the assets to be discounted in determining its fair market value for estate and gift tax purposes. These discounts (for lack of marketability and minority interest), determined by appraisers and confirmed in numerous decisions of the Tax Court and Federal appellate courts, often range from 25% to 40% or more.

For example, assume that a person owns investment real estate or marketable securities in a family partnership that had been worth $4 million in 2007, but today is worth only $2 million. Assume further that the assets will return to 2007 values over the next five years. The owner would like to transfer 40% of the appreciation over the next five years to each of his two children. A qualified appraiser determines that a minority interest in the family partnership has a value that should be discounted 35% from the value of the partnership’s underlying assets. The grantor establishes a five-year GRAT for each child and transfers 40% of the family partnership to each GRAT. The Trust provides that the grantor will receive an annuity payment of approximately 22.2% of the initial value of the transferred property per year for the next five years. The initial value of the transfer to each GRAT is 40% x $2,000,000, less a 35% discount, or $520,000. The GRAT payment has been set to return the $520,000 starting value plus 3.6% interest to the grantor, so there has been no gift. If the assets appreciate as expected, at the end of the five years, each GRAT will still own approximately 20% of the family partnership with assets now valued at $4 million. This interest is now owned by the children, with no gift or estate tax.

Other estate planning techniques employ these same factors to transfer wealth to heirs and/or benefit charity, including sales to Intentionally Defective Grantor Trusts (IDGT), Charitable Lead Annuity Trusts (CLAT) and Qualified Personal Residence Trusts (QPRT). Consult with a JMBM estate planning lawyer to determine which techniques may be suitable to your circumstances.

The convergence of these economic factors may provide an opportunity for tax-efficient wealth transfer that may not be seen again for 20 years. In addition, there may well be changes in the law in 2009 that could permanently eliminate some or all of these techniques. For example, for more than 10 years the IRS has proposed eliminating estate and gift tax valuation discounts on non-business property. While this has not yet been enacted as law, the IRS has vigorously litigated discount valuation cases on many grounds in recent years. A new administration aligned with a strongly Democratic Congress, may be willing to enact IRS proposals that would curb the use of discount valuations. In addition, if a substantially increased estate tax exclusion (perhaps $3.5 million per person) and portability between spouses are enacted, Congress may seek offsetting revenue from transfers that otherwise avoid the estate and gift tax system, such as the techniques discussed above. Finally, such sweeping changes would likely not be enacted with a window before their effective date to allow time to accomplish significant planning under current law. An effective date of January 1, 2009, or an uncertain date, such as the date of introduction of the bill that results in such legislation, are possible. Now is the time to take advantage of current law and find the silver lining in today’s economic black clouds.

Gordon A. Schaller is a Partner in the Taxation Group at Jeffer, Mangels, Butler & Marmaro LLP. He focuses his practice on tax, estate planning, business succession, charitable and wealth management services and trust and estate litigation. For more information, please contact him at 714.429.8208 or