Estate Tax and Business Succession Planning
By: Anthony J. Enea, Esq.*
Estate, Gift and Generation Skipping Taxes
I. The Economic Growth and Tax Relief Reconciliation Act of 2001
A. Repeal of Estate Tax?
On May 26, 2001 Congress passed the Economic Growth and Tax
Relief Reconciliation Act of 2001 (hereinafter “Tax Act”). President George W. Bush signed it into law on June 7, 2001. The Tax Act is subject to a “sunset provision”, which provides that unless Congress votes to reauthorize the legislation, it will expire on December 31, 2010 and pre-Act law will then go into effect.
The Tax Act repeals the Estate Tax over a ten year period.
The exemption amount will be increased and the tax rates lowered
as per the following schedule:
|Calendar Year||Exemption Amount for
Transfers at death
|2010||Estate Tax Repealed|
B. Generation Skipping Taxes (“GST”) Until 2004, the rules regarding the GST will remain unchanged. The present exempt amount is $1,060,000 as indexed for inflation. The exemption will continue to be indexed for
inflation in 2002 and 2003. However, commencing in 2004, the GST exemption will equal the exemption amount for transfers at death. For the years 2002-2009 the GST tax rate will equal the top estate tax rate. In the year 2010 the GST tax is also completely repealed.
C. Gift Taxes
Under the new Tax Act the highest gift tax rate will be reduced according to the same schedule in effect for the highest estate tax rate. However, effective in 2010 the highest gift tax rate will be reduced to the highest income tax rate effective in 2010. The lifetime gift tax exemption is increased to $1,000,000 on January 1, 2002 and stays at that level for an indefinite period without any indexing for inflation.
New Cost Basis Rules
– After the repeal of the estate tax, the current rule that property acquired from a decedent receives a step up in basis will no longer be applicable.
– Executor will be able to allocate an aggregate basis increase of $1.3 million adjusted for any of the decedent’s unused built-in-losses and lost carry overs. This basis increase is adjusted to $60,00 in the case of estates of decedents who were not residents or citizens of the United States.
– A $3,000,000 basis increase permitted for property that passes to a surviving spouse, either outright or in the form of a qualified terminable interest (QTIP) after 2010 these amounts are subject.
– No basis increase will be allowed for property that is acquired by the decedent within three years of death, unless it was acquired from a spouse or for full and adequate consideration.
State Death Tax Credit
For the years 2002 through 2004, the state death tax credit will be reduced; thereafter it will be replaced by an estate tax deduction for state death taxes that are actually paid. Changes will be implemented as follows:
|Calendar Year||Reduction from Current Credit|
Credit is repealed and replaced with deduction
Once the estate tax is repealed information returns will need to be filed for estates with a value in excess of the basis increase amount ($1.3 million in 2010) or includes appreciated property acquired by the decedent within three years of death.
Implications and Planning Strategies
1. Review and updating of current Wills and Trusts to ensure that implications of the Tax Act are considered. For example, if a Will with Credit Shelter Trust is being utilized by clients which utilizes a formula designed to leave the exempt amount ($675,000) in trust for the benefit of the surviving spouse which will bypass his or her estate.
However, under the new law as the exemption amount increases, the formula could cause the entire estate to be held in trust for the surviving spouse, thus, leaving few or no assets passing outright to the surviving spouse.
2. Review with clients the changes in the carry over basis rules taking effect in 2010. A plan should be implemented to take advantage of the $1.3 million basis increase plus the $3 million spousal basis increase, for example, it may be advisable to give written instructions to executor of Will as to how the value of basis increases should be allocated as it will effect the heir’s inheritance.
3. Recommendations should be made by all Tax Professionals to their clients regarding keeping track of cost basis of assets and retaining all records including records of capital improvements to real estate.
4. With exemption increasing to $1 million on January 1, 2001, gifting programs should be reviewed and recommended.
5. Married couples should ensure that title of assets owned is property balanced to take advantage of the increasing exemption amount in each spouse’s estate.
6. Business Succession planning should be re-evaluated in light of the new carry over basis rules.
II. Utilizing the Exemption Amount to your Advantage
– Married couples who are U.S. citizens get a special break on estate taxes known as the “unlimited marital deduction”. Husband and wife during their lifetimes and upon death can transfer unlimited amounts of assets and property to each other without any estate or gift tax consequences. However, upon the death of the second to die of husband and wife, estate taxes, if any are due, can be reduced or eliminated if proper use of the exemption amount has been taken advantage of during the lifetime of both husband and wife.
– The Unified Gift and Estate Tax Credit allows everyone to make taxable gifts or transfers of assets during their lifetime or upon their death which are exempt from estate and gift taxes:
|2002 and 2003||
|2004 and 2005||$1,500,000|
|2006, 2007 and 2008||$2,000,000|
– Proper utilization of the exemption amount in both the estate of a husband and wife can save the estate of the second to die hundreds of thousands of dollars in estate taxes.
– Last Will and Testaments or Living Trusts which contain what are known as “Credit Shelter Trust Provisions” will allow both a husband and wife to take full advantage of the Exemption amount in each of their estates upon their demise.
– Credit Shelter Trust provisions in a Last Will be ineffective if there are not sufficient assets in the decedent’s name alone on the date of death so as to utilize the exemption on date of death.
III. Exemption Amount Planning with a Credit Shelter Trust
1. Formula clauses define either credit shelter amount/share or optimum marital amount/share; can be a pecuniary amount or fractional share of residuary estate. In the event a formula is utilized, it will be a pre-
residuary bequest inserted immediately before the residuary; the residuary would then dispose of the other portion of the estate not disposed of by the formula.
2. When the pecuniary bequest is a specified dollar amount, it will not share in appreciation or depreciation of the estate’s assets. However, a pecuniary bequest in trust does share in income of the estate (see EPTL §11-2.1[d]); capital gain or loss will be realized when a pecuniary bequest is satisfied by distribution of appreciated or
3. With a fractional bequest, the beneficiary shares in the appreciation or depreciation and income of the estate, no gain or loss realized on funding and accounting can be complicated.
4. Credit shelter amount/share can be distributed to non-spouse beneficiaries including trust that does not qualify for marital deduction (e.g. sprinkling trust).
5. Marital deduction amount/share must be disposed of to or for the benefit of spouse in a manner qualifying for the federal estate tax marital deduction: outright, QTIP, QDOT (non-citizen spouse), life estate with general power of appointment or estate trust.
6. QTIP trust is a common alternative because it allows testator to control disposition of remainder and allows for reverse QTIP election for GST purposes; but consider right of election issues.
IV. Life Insurance Trusts
– The goal of planning with an irrevocable life insurance trust is to avoid the inclusion of policies in the insured’s estate under I.R.C. §2042
– The estate of an insured will include proceeds payable to others where the insured retained or possessed any “incidents of ownership” under §2042(2) of I.R.C. Examples of “incidents of ownership”:
(a) Power to change beneficiaries or contingent
(b) Power to borrow under the policy;
(c) Power to surrender or cancel policy;
(d) Power to assign the policy or revoke an assignment;
(e) Power to change time and manner of receipt of proceeds.
– To avoid any of the “incidents of ownership”, third party ownership of insurance is frequently utilized. A properly structured Irrevocable Life Insurance Trust (“ILIT”), under which the insured has no rights with respect to the policy will permit exclusion from the estate of the insured the proceeds of insurance (death benefit) upon his or her death.
– The “ILIT” will generally apply for, purchase and hold the new insurance policy during the life of the insured. In the event an existing life insurance policy is assigned from the insured to an irrevocable trust, the insured must survive for three years from the date of the transfer to avoid having the death benefit of the policy being included in his or her estate for federal estate tax purposes. See I.R.C. §2035(a) and 2042.
– The assignment of an existing policy by an insured to an irrevocable trust is a gift for federal gift tax purposes. The valuation of rights of life insurance are determined under Reg. §25.2512-6. For ex: the value of a paid up whole life policy is the cost of a new replacement policy.
– Once the trust owns the policy, each year the Grantor(s)/Insured(s) will make gifts to the trust to enable the trust to pay the premiums due. In order for the gifts to the trust to qualify for the $10,000 gift tax annual exclusion, the trust beneficiaries must have “Crummey” powers of withdrawal. This will allow the transfer to the trust (gift) to satisfy the present interest requirement and thus, qualify for the $10,000 annual exclusion.
– Beneficiary must be given notice of Crummey, Power – 30 days according to IRS – PLR 9232013 – 15 days Tax Ct. Cristofani v. Commissioner 97T.C.N.5 (1991)
– Second to Die Life Insurance Trust – pays benefit on death
of the survivor of a husband and wife – commonly used – less
expensive than single life and it provides liquidity at a time it
is most needed.
– Where large premiums are involved (above annual exclusion
amount), a split-dollar arrangement should be considered if option available – split-dollar- uses employer to provide funds
to pay a portion of the premiums.
Advantages of “ILIT”
(a) Death benefit passes free of estate taxes
(b) Creates liquidity (immediately) to pay estate taxes
that may be due – especially important in estates with
large real estate holdings
(c) Helps avoid fire sale of estate assets when estate
taxes are due within nine months of date of death.
V. Family Limited Partnerships
– Family Limited Partnerships (“FLP”) are used as an estate
planning tool to depress gift tax values. I.R.C. §2503(b),
20326(a)(2), 2038, 2701 and 2704 – Codes to consider.
– Typical scenario for an FLP – Husband and Wife each contribute property to FLP and receive in exchange for the property contributed each receives a one percent general Partnership interest and a forty nine percent limited partnership interest. The contributions to the FLP can be unequal in which case one spouse would receive a greater limited partnership interest than the other. The transfer of the property to the FLP is a capital contribution with no tax implications. However, once the limited partnership interests are gifted to family members there are tax implications.
– Tax Implications of Gifting, Limited Partnership Interests
(a) Discount of dollar value of limited partnership
interest gifted for “lack of marketability and minority interest”;
(b) Amount of discount taken generally anywhere from thirty to forty percent see Samuel J. LeFrak 66 TCM 1297 –
thirty percent discount permitted for real property;
(c) The gifts are eligible for the annual gift tax
exclusion ($10,000 per donee);
(d) The gifted property is not includible in the donor’s
gross estate – although General Partners have control.
Although limited partnership interests have been transferred, the General Partner is still able to maintain control over the FLP by: (a) retaining investment power over FLP assets as per FLP agreement; and (b) retaining power to determine timing of distributions to partners (c) determine who should receive management fees (generally net profits of FLP) and (d) determine whether additional obligations will be incurred by the FLP.
Advantages of an FLP
1. The timing of cash flow to limited partners can be
controlled by the general partners;
2. Holding of multiple assets by a single entity may reduce
3. Interest in an FLP is considered personal property and
out of state real property owned by the FLP is not subject to
probate and related costs;
4. Difficult for creditors of a limited partner to reach
5. The FLP in comparison to a corporation may be terminated
without adverse tax consequences
6. The limited partnership interest is segregated and if
its separate property characterization is maintained it may be a
difficult interest to reach in event limited partners is
IRS Challenges to FLP’s
In 1997, the IRS National Office issued five technical
Advise Memoranda delineating various grounds to challenge FLP’s
which, if successful would result in disregarding the Partnership
and valuing the underlying assets. See Letter Ruling 9719006,
9723009, 9725002, 9730004, 9735003.
Potential Grounds for Disregarding FLP’s are:
(a) The partnership lacks economic substance and valuation
should be based on “substance over form”. For example;
not truly conducting business as a FLP – no business
(b) The transfer should be analyzed as a “step transaction”
with the partnership a disregarded intermediate “step”
and the end result a transfer of the underlying assets;
(c) The partnership lacks a business purpose
(d) The partnership agreement itself is a (restriction on
the right to sell or use( the underlying property as
described in I.R.C. §2703(a)(2) and should be
IRS scrutiny of FLP’s has become increasingly vigilant in