As 2015 comes to a close, Steptoe’s private client practice would like to take this opportunity to highlight some of the year’s important legal developments affecting estate planning, as well as certain year-end planning opportunities that may be of interest.

The following summarizes some of the relevant legislative developments, proposals, and areas as to which the IRS is expected to give guidance.  Many of the budget proposals discussed below were included in past years and were not passed, but it is important to keep in mind that these are areas targeted by the administration.  Therefore, it may be prudent to take advantage of some of these planning techniques while they are still viable options.

Lifetime Gifting

  • Lifetime Applicable Exclusion Gifting
    • Historically high federal estate, gift, and generation-skipping transfer (GST) tax applicable exclusion amounts may be used to make gifts during your lifetime or at death.  The amount is currently capped at $5,430,000 but increases due to inflation to $5,450,000 in 2016. 
    • Gifts made during your lifetime remove both the value of the gifted property as well as any appreciation on that property from your taxable estate, thus minimizing what is taxed at your death. 
    • It is important to be aware that President Obama has included in his 2016 proposed budget a reduction in the applicable exclusion amounts to the 2009 levels of $3,500,000 for estate and GST tax purposes, and $1,000,000 for gift tax purposes.  Therefore, it may be appropriate to consider current gifting if you have not already given away the full $5,430,000 available currently.
    • Lifetime gifts may often be leveraged through valuation discounts for lack of marketability and lack of control.  However, proposed regulations are expected to be issued under Section 2704 of the Internal Revenue Code, which may limit valuation discounts that apply to certain family owned businesses.
    • Lifetime gifts may be further leveraged by the use of dynasty trusts to which GST tax exemption is allocated.  These transfers allow property to pass in trust for the benefit of multiple generations free of estate, gift, and generation-skipping transfer tax.  Budget proposals would limit the GST exclusion to 90 years for additions to a pre-existing trust and to a new trust regardless of the trust’s term.
    • Annual Exclusion Gifting
      • Annual gifts may be made of up to $14,000 per person to an unlimited number of individuals without consuming any of your lifetime exclusion amount or incurring a gift tax.  The annual exclusion gifting amount remains at $14,000 per donee for 2016.  A married couple together will be able to gift $28,000 to each donee.  The limitation on annual gifts made to noncitizen spouses will increase from $147,000 to $148,000 in 2016.
      • The maximum rate for federal estate, gift, and GST tax remains at 40%.
      • For the last two years, budget proposals have created a new category of transfers, which includes transfers to trusts, pass-through entity gifts, and certain restricted transfers, and imposes an annual limit on how much would qualify for the annual gift tax exclusion of $50,000 per donor on such transfers.  Although this is simply a proposal right now, individuals using annual exclusion gifts to fund insurance trusts and to make gifts to family members may need to consider alternative funding arrangements should laws be enacted with these limitations.
      • Income Tax Considerations
        • State transfer tax laws must also be taken into consideration.  For example, although New York has raised its estate tax exemption to match the federal exemption, the increase is phased in over several years and will not fully match the federal exemption until 2019.  In addition, the NY exemption is eliminated entirely for those estates that exceed the exemption amount by more than 5%.  NY also includes certain lifetime gifts made between April 1, 2014 and January 1, 2019 and within three years of death in the decedent’s NY taxable estate.
        • Property included in your taxable estate receives a step-up in basis.  Assets gifted during your lifetime will not receive a step-up in basis at death.  Therefore, income tax considerations must be taken into account in deciding whether to make lifetime gifts.  Higher income tax rates mean that maximizing the basis step-up allowable at death may be as important as minimizing transfer taxes, as the maximum income tax and transfer tax rates are now almost the same.
        • Individual ordinary income tax rates will not change in 2016, with a maximum rate of 39.6%.  For taxpayers whose ordinary income is taxed at the maximum 39.6% level, long-term capital gains continue to be taxed at 20%.  Long-term capital gains for taxpayers in lower ordinary income tax brackets continue to be taxed at 15% or 0% if the taxpayer’s ordinary income is taxed at 10% or 15%.  Qualified dividends are taxed at the long-term capital gains rate, i.e., at 20% for those taxpayers in the top bracket.
        • The threshold for the imposition of the 3.8% Medicare surtax on investment income and 0.9% Medicare surtax on earned income also remains the same in 2016 for individuals ($200,000 for single filers, $250,000 for married filers filing jointly, $125,000 for married filers filing separately), but rises to $12,400 for trusts and estates.  Therefore, some or all of the Medicare surtax may be avoided by distributing trust income to beneficiaries who are below the individual net investment income threshold amount for the Medicare surtax.

Consider Grantor Retained Annuity Trusts (GRATs) and Sales to Defective Grantor Trusts to RemoveAppreciation From Your Taxable Estate

  • Low interest rates continue to make GRATs and sales to defective grantor trusts attractive and effective planning tools.
  • GRATs
    • A GRAT requires that the grantor retain a fixed annual annuity from the trust for a term of years.  The annuity retained may be equal to 100% of the amount used to fund the GRAT, plus the IRS assumed rate of return applicable to GRATs.  As long as the GRAT assets outperform the IRS assumed rate of return (currently two percent for December 2015), at the end of the annuity term the grantor will be able to achieve a transfer tax-free gift of the spread between the actual growth of the assets and the IRS assumed rate of return.  Under current law you can structure a GRAT so that no taxable gift is made.  Although the grantor will retain the full value of the GRAT assets, if the grantor survives the annuity term, the appreciation on those assets could pass outside of the grantor’s estate without using any applicable exclusion amount and or incurring any gift tax. 
    • Recurring budget proposals would adversely affect how GRATs are structured and their usefulness in estate planning.  Current proposals include a requirement that a GRAT have a minimum 10-year term and a maximum term of no more than 10 years over the grantor’s life expectancy,  a requirement that the remainder interest be at least equal to the 25% of the value of the assets contributed or $500,000 and a prohibition against tax-free exchanges of assets held in the trust.  Passage of these proposals would make it impossible to structure a GRAT so that no taxable gift is made.
    • Sales to Intentionally Defective Grantor Trusts (IDGTs)
      • The grantor of an IDGT is treated as the owner of the trust assets for income, but not estate tax, purposes.  Thus, a grantor may sell assets that are likely to appreciate to an IDGT in exchange for a reasonable down-payment and a promissory note bearing a minimum required interest rate for the balance.  No taxable gain is recognized on the sale and no interest income is recognized by the grantor because the trust is a grantor trust for income tax purposes.  So long as the trust assets appreciate by more than the applicable interest rate charged on the note (a different rate than that used for GRATs, which currently is 0.56% for short term loans or 2.61% for long term loans entered into in December 2015), the appreciation over the applicable interest rate on the purchased assets will pass free of estate and gift tax. 
      • The grantor pays the income tax liability on the IDGT assets, which allows the principal to grow undiminished by the payment of income taxes.  Because the grantor is the owner of the assets for income tax purposes, the grantor’s payment of the IDGT’s income taxes is not treated as a gift to the trust beneficiaries even though it results in an increased amount of trust assets available for distribution.
      • Budget proposals contain provisions that would significantly reduce the utility of IDGTs.  Under the proposals, the assets in many IDGTs would be included in the grantor’s estate and subject to estate tax, except to the extent consideration is received by the grantor from the IDGT.  In addition, distributions from an IDGT would be subject to gift tax and if the trust ceases to be a grantor trust, the remaining assets would be subject to gift tax.
      • Anticipated proposed regulations under Section 2704 of the Internal Revenue Code may also limit the utility of sales of discounted family business interests to IDGTs.

Consider Making Year-End Charitable Gifts

  • If you have not reached the limits of your charitable contribution percentage limitations, direct contributions to charity before year end may be appropriate.  Particularly in this time of higher income tax rates, charitable income tax deductions are more valuable.

International Considerations

  • A Report of Foreign Bank and Financial Accounts (FBAR) must be filed by those who have a financial interest in or signature authority over a foreign financial account.  Those required to file FBARs should note that for taxable years beginning December 31, 2015, FBARs are now due April 15 rather than June 30.  A six-month extension will now be allowed, whereas no extension was permitted previously. 
  • Citizens of European Union member states, US citizens with assets located in EU member states and individuals with a habitual residence in an EU member state should be aware of the European Succession Regulation that became effective August 17, 2015.  The regulation provides for the application of one uniform law governing succession across all EU member states and was adopted by 25 countries in the EU.  It provides individuals the ability to choose the law of nationality to govern their estate, thus affording the opportunity to bypass potentially undesirable laws of EU member states where property is located, such as community property and forced heirship rules.
  • Proposed regulations have been issued providing guidance with respect to gifts from covered expatriates to US persons.
  • The Foreign Account Tax Compliance Act (FATCA), a federal law requiring US persons (including those living outside the US) to annually report their foreign financial accounts to the Financial Crimes Enforcement Network, also requires all foreign financial institutions to search their records for US persons and report their assets and identities to the US Treasury.  Twenty-two additional countries signed FACTA Intergovernmental Agreements with the United States in 2015 including Belarus, Cambodia, Colombia, Croatia, Georgia, Holy See, Iceland, India, Kosovo, Kuwait, Montserrat, the Philippines, Portugal, Qatar, Romania, St. Kitts and Nevis, St. Vincent and the Grenadines, the Slovak Republic, South Korea, Turkey, United Arab Emirates, and Uzbekistan.
  • On July 15, 2015, 53 international jurisdictions signed an agreement to automatically exchange information on residents’ assets and income automatically in conformity with what is known as the “Common Reporting Standard” (CRS).  The goal is to identify the financial assets of non-residents held in off-shore financial centers so that they may be subject to tax by home revenue authorities.  Automatic reporting will include account balances and gross amounts of interest, dividends, capital gains, and other income of account holders and look-through non-financial entities and their controlling persons.  The US has not committed to the CRS.  The CRS reporting standards are broader than those of FACTA and may require providing information regarding different aspects of trusts such as beneficiaries and grantors.

Planning and Year-End “Housekeeping” to Remember and Consider

  • Now is a good time to review your current estate plan, particularly if you have had major life events such as a marriage, divorce, or birth of a child or grandchild.
    • Review will and trust provisions for formulas that may no longer accurately reflect your dispositive wishes.
    • Consider whether existing trusts need to be decanted to adjust the way property is distributed to certain beneficiaries by changing the trust provisions.
    • Review all beneficiary designations to ensure that they do not conflict with your overall testamentary plan.
    • Make sure that all necessary “Crummey Notices” have been sent to appropriate parties to ensure that corresponding gifts made in trust qualify for the annual exclusion (particularly applicable to insurance trusts).
    • Consider refinancing high rate intra-family loans.
    • Consider distributing assets out of irrevocable trusts to attain a step-up in basis on the beneficiary’s death, but also take into account estate and gift tax and creditor protection consequences of taking protected property out of trust.
    • Consider swapping low basis assets for higher basis assets held in grantor trusts so that lower basis assets will be includible in your taxable estate and receive a step up in basis on death.
    • Maximize annual IRA contributions.