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Lesson 7 Tax 526

1. What types of transfers will result in taxation under the GSTT rules?

GSTT is applied to transfers made to donees and beneficiaries who are two or more generations below the transferor. A generation is defined in reference to the transferor. If the transferee is more than 12.5 years younger than the transferor, the transferee is considered to be first generation (such as a parent and a child). If the transferee is more than 37.5 years younger than the transferor, the transferee is considered to second or further removed generation (such as a grandchild or any non-relative). When a transfer is made to a second or further removed generation, if the property value exceeds the GSTT exemption amount, it will be subject to GSTT. This tax was created to capture tax on transfers that would have been subject to taxation if they had been transferred through the direct line of generations. Prior to 1976 law1, a transferor was able to ‘skip’ a generation and keep property within the family line and avoid taxation by transferring property directly to a younger generation. The tax reform Act of 1986 set up the current framework for how GSTT gets imposed.

The tax is imposed on direct skips (over first generation), taxable distributions, and taxable terminations. A taxable transfer can also be created when transfers are made indirectly to beneficiaries named in a trust, such as a remainder trust. When a beneficiary has a beneficial interest (such as Crummey withdrawal powers2, or an immediate right to principal and interest). A taxable distribution of principal or interest to a skip person can trigger GSTT. The taxable amount is the net value of the property received by the skip beneficiary, reduced by any amount he or she paid in consideration for the distribution and increased by any amount of GSTT paid by the trustee on the distribution. A taxable termination occurs when there is a termination of property interest held in a trust. For example, when trust income is directed to a non-skip generation beneficiary with the remainder interest directed to a skip generation beneficiary at the non-skip beneficiary’s death, GSTT will be triggered. This is because despite both skip, and non-skip interests in the trust, the GSTT is applicable when there is no longer a non-skip interest and the interest belongs purely to a skip generation beneficiary. These transfers may also be subject to gift tax as well as GSTT. GSTT does not apply if the parent of the skip generation transferee is deceased prior to the transfer. The tax is flat rate of 40%.

1. What is the current $3.5 million exemption against the GSTT, and how should the taxpayer allocate the exemption?

The current exemption against GSTT is 11.18 million for 2018. A strategy used to allocate the exemption is to apply the exemption to lifetime transfers of appreciating property because it is assessed at the current fair market value on the date of the transfer and can continue to appreciate without being subject to additional taxation. Another strategy is to use the exemption on life insurance premiums on a policy placed in an irrevocable trust for a skip generation beneficiary. The exemption applied to the premiums will be sheltered from GSTT and the life insurance proceeds would be tax free to the beneficiary.

3. Describe the manner in which the IRS will allocate the GSTT exemption at a transferor’s

death if the exemption is not allocated by the decedent.

Once a transferor dies, the remaining exemption (if any) is allocated first to remaining direct skip transfers and then to direct skip trust transfers3. If those transfers are partially exempt, the exemption is applied ratably. In the case of testamentary trusts that have potential for a taxable distribution, taxable termination (such as a bypass trust) the exemption is applied ratably to these as well. This creates complexity because the trust partially exempt. Therefore, planning is recommended to make trusts either wholly taxable or wholly exempt to avoid additional cost with calculation of the tax. The other rule to consider is that, if the decedent did not elect the exemption at the tie of the gift transfer, the GSTT consequences are based on the value of the property at the time of the allocation (generally, a significantly higher value) (Eileen, R. S. (1997).

1. What are the advantages of an installment sale

1. from the standpoint of the seller

There’s a lot of benefit to an installment plan from the standpoint of the seller. From an income recognition perspective, the income from the sale is recognized over a period of years. The income is characterized as a portion of gain, interest, and return of capital with each payment. By recognizing income over time, the seller is not hit with the full tax ramification if the sale were made in one single transaction. Another benefit is the reduction of estate size by selling the asset. The value of the asset is fully transferred at the initial sale date. This is helpful when the property is expected to increase in value. The value of the property is effectively frozen while any appreciation of the property will be in the hands of the buyer.

1. from the standpoint of the buyer

The most obvious benefit to the buyer is that the sale is transacted requiring funds at a reduced amount than would be required at a non-installment purchase. For a buyer with limited income this is useful tool to defer payment over the installments. Another benefit is the possibility to use the interest portion of payments as a deduction on the buyer’s income tax return.

1. How can an installment sale be used as an estate-freezing technique?

On the date of the initial sale, the property is valued at the amount that would typically be included in the estate. Assuming the sale follows proper arm’s length rule, none of the value of the transferred property will be subject to gift tax. With the installment method, only the amounts of principal and interest already received (if still in possession of the decedent) plus the present value of remaining installment payments will get included in the estate. This provides a reduction in estate value while freezing the property from any appreciation it may accumulate because the appreciation belongs to the purchaser.

1. What is a private annuity and how is it useful for estate planning purposes

A private annuity is in essence a sale of property similar to the installment method in that payments are received over a number of years. The seller transfers a property in exchange for the annuity payments which are based on present value of the fair market value at the date of the annuity. The amount of payments divisible to the present value is calculated over the number of years of the annuity. Since the property is valued at fair market value, there is no gift tax attributable to the annuity because equal consideration will be received through the annuity. The value in estate planning, is that first, because it is a sale, any future appreciation is not includable in the decedent’s estate. The property can now be used as a source of income for the estate owner. Although proposed treasury regulations in 20064, require the seller to recognize all of the gain immediately, a second benefit to estate planning is that any remaining annuity payments at the death of the transferor will not be included in the transferor’s estate. The benefit for a family member making the annuity payments is that payments automatically end when the transferor dies no matter how many payments are remaining.

1. Explain the gift tax consequences when a grantor transfers a personal residence to an irrevocable trust and retains a term interest with the remainder to his or her children.

When the property is placed in the irrevocable trust, the value of the transfer subject to gift tax is the value of the property, less the value of the retained interest by the grantor. This reduces the value of the property transferred and effectively reduces the balance subject to gift tax. Sine the transfer is only a future benefit to the beneficiary, the annual gift tax exclusion is not allowed to reduce the value any further. Instead the grantor may use the basic credit amount (if any) to reduce any (if not all) gift tax on the transfer.

1. What are two problems involving spousal cross-ownership of insurance?

If cross-ownership is set up at the outset, meaning each spouse has a policy on the other, this avoids any need for transfer of ownership at the risk of violating the 3-year rule under IRC §2035. If only one spouse is insured and is predeceased by the policy-holding spouse, the policy may get transferred back to the insured spouse’s estate causing the strategy to backfire, defeating the purpose of the cross-ownership. Another risk to consider is incident of divorce. The property settlement outlined in the divorce agreement would most likely require a restructure of the life insurance arrangements.

1. How should an irrevocable life insurance trust be drafted to provide solutions to estate liquidity problems without the proceeds being deemed payable to the executor?

Two traps to be avoided when drafting an irrevocable life insurance trust are incidents of ownership by the grantor, and proceeds made payable to the estate. If the policy to be placed in the trust is an existing policy, this increases the risk of incident of ownership if the policy owner is the grantor or the policy is transferred within three years prior to death. For this reason, it is recommended that the trust is created prior to application for life insurance. The applicant should be the trustee and the grantor is the insured. The proceeds can be payable to the trust. The trust should not name the estate as the beneficiary of the trust. When the trust is drafted, provisions should be included that the trustee has discretionary powers to use the trust funds to lend funds to the estate or purchase assets from the estate. This is how the trust can be used to provide liquidity to pay estate taxes without including the proceeds in the estate itself.

1. Explain the methods frequently used for postmortem planning.

Postmortem planning tools can be used to adjust the estate plan in the most beneficial way for the estate and its beneficiaries:

• Qualified Disclaimer – there is a time limit of 9 months once the decedent has passed to use this tool and should planning mistakes be discovered, this mechanism can be used to redistribute property and redistribute the tax consequences as necessary

• Current-Use/Special-Use Valuation of Closely Held Property – under IRC §2032A business property valued at current use can help reduce estate valuation and reduce estate taxes

• IRC §303 – Stock Redemption – allows a stock redemption to assist with liquidating funds so long as they are used for allowable estate costs

• Alternative Valuation Date – The estate assets may have a reduced value at either the date of death or the alternate valuation date, 6 months later. Assets sold between the date of death and the alternate date are deemed valued at the sale price. Using an alternate date may assist with reduction of estate value.

• Marital Deduction Qualification of QTIP Trust Property – this deduction allows a marital deduction for the property transferred to the surviving spouse. This property provides an income interest to surviving spouse and corpus transfers to beneficiaries upon the surviving spouse. This gives a reduction the estate of both spouses with its exclusion.

• Split Gifting – the Service allows a postmortem election of gift splitting on lifetime transfers. This increases the amount remaining in the estate exemption and reduces tax.

• Extension on Time to Pay Estate tax on Closely Held Businesses – If 35% or more of an estate is a closely held business, the estate may qualify for an extension of time to pay tax which reduces the immediate burden to pay.

• Family Allowance – This reduces the estate by providing an allowed sum of money for surviving spouse and children.

• Election Against the Will by Surviving Spouse – a decedent may not exclude a spouse altogether from a will and must provide a specified minimum percentage of the estate so that the spouse (and children) do not become a burden to the state.

• Deduction of Administrative Expenses and Medical Expenses – can either be deducted on the Estate Tax Return or the Estate Income Tax Return and therefore the most beneficial choice can be made on where to deduct these expenses

• Executor’s Fees as a Bequest or Income – a decision can be made on whether or bequest or a payment to the executor results in the best outcome for the reduction in estate taxes

1. Identify the different types of powers of attorney

The three basic types of powers of attorney are:

• Durable Power of Attorney – this is an inexpensive way to ensure the estate-holder’s choice of executor while avoiding delays with a court-appointed executor. It also allows the principal to grant someone power during incapacitation.

• Special / Limited Power of Attorney – grants authority to perform specific tasks for a specific period of time.

• Springing Durable Power of Attorney – is operative only in the case of a triggering event which is defined in the document (such as physical or mental incapacity)

1. Explain some of the problems that can arise with bequests to a surviving nonmarital partner under a decedents-partner’s will.

When bequests are made to nonmarital partners under a will, challenges to the will by family members may arise. A surviving partner may receive less than the bequest or nothing at all as a result. There are alternative methods to ensure that the surviving partner is provided for without use of the will. A revocable trust with the surviving partner named as the beneficiary would become irrevocable at death with property transferable to the surviving partner. An irrevocable life insurance trust with the surviving partner named as the beneficiary would also ensure the partner is provided for. This is helpful when the surviving nonmarital partner does not have access the decedent’s pension benefits. Should the relationship dissolve prior to death, the irrevocable trust could have provisions that an alternate beneficiary named would receive the assets in certain specific situations. Another method is using a grantor retained interest trust. Assets placed in the trust with a remainder interest would only require gift tax on the non-remainder interest portion and therefore reduce any gift tax liability should a gift be made outright.

References

1. Eileen, R. S. (1997). Beware not allocating the GSTT exemption on a gift tax return-a trap for the unwary. The Tax Adviser, 28(8), 514-516. Retrieved from https://search.proquest.com/docview/194945848?accountid=158450