- ABA Groups
- Resources for Lawyers
- About Us
With November quickly approaching and a Republican White House and Congress within the realm of political possibilities, some estate planners believe that the repeal of the transfer tax system is an eventuality, especially after the Senate passed H.R. 8, the Death Tax Elimination Act of 2000, 106th Cong., by a huge margin on July 14, 2000 (which at this writing had not yet been vetoed by the President). Others believe that the taxes are here to stay.
Should this have any effect on planning? The short answer, of course, is, "it depends." Uncertainties about the potential of tax reform should not prevent planners from considering the impact such a change might or should have, however, on the wealth transfer planning advice and counsel they provide to their clients.
No matter what advisors think about the chances of estate tax repeal, they should let their clients contemplate the probability of repeal. Advisors should carefully analyze the individual circumstances of each client, including the client's age, health, wealth, risk aversion and needs for non-tax planning, before deciding whether any discussion of the potential transfer tax repeal is warranted. This author does not believe that advisors have a duty to warn past or present clients of the potential reform, but the issue is one to consider for those clients who are in the midst of planning.
Once advisors determine that some level of consideration is to be given to potential changes in the system, they must figure out where to start and how deep that discussion should delve. Initial discussions might include a review of the history of the transfer tax system, including its reasons for enactment and the number of times that the tax has been repealed and later reenacted. Following such a trip back in time, advisors might discuss revisions to the system, including the increase in the unified credit-now the "applicable credit amount"-and other taxpayer-friendly legislative developments, followed by recent attempts to change the system, such as the attempts to lower the marginal rates or to completely repeal the entire transfer tax system. Advisors might also discuss the current makeup of both Houses of Congress and the possible effect that changes in the upcoming election might have on the potential for transfer tax modifications.
Clients will inevitably ask whether the advisor thinks the laws will change. Firms with Washington connections or offices may be closer to the pulse of Congress, but for most advisors, just being familiar with the applicable statutes does not necessarily mean that the advisor is any more competent than a lay person to comment on the political process. Even advisors who are convinced that they know the outcome should at least give some heed to the possibility that they are wrong. Finally, clients still should consider the possibility that the system, or a modified version of it, could later be reenacted after such a repeal
After a discussion of the likelihood of a transfer tax repeal, advisors should outline the possible consequences of a repeal to clients. Will the clients' complicated plans be needed? Will they still work? Will the clients have unnecessarily paid gift taxes or have needlessly locked up assets in trusts or other devices beyond reach? Some clients may only need to make minor changes to testamentary instruments to reflect their desires in a post-estate tax environment, but clients engaging in lifetime giving and more complicated plans, especially those considering large taxable gifts, will have different issues to consider. Some clients may believe that they will live long enough to see the transfer tax completely abolished and will therefore prefer to make their estate plans free from such tax considerations. Some clients may unfortunately see the possibility of an estate tax repeal as a reason to postpone any planning. Advisors should take great pains to demonstrate this choice as an unwise decision.
Other clients might decide that transfer taxes will never be repealed and will desire the "classic" plans in use today. Many more clients are likely to fall between these extremes. Some will realize that they cannot be certain that the tax system will be overhauled but will want to allow for the possibility. These clients may want to hedge their transfer tax planning by trying to plan for the prospect that they might die before such a repeal, while still leaving an escape hatch if the laws later change.
In any event, advisors who are leading clients through decisions that are based on the contingency of estate tax reform will need to concentrate initially on the basics of planning. Planning for the mere possibility of statutory changes is well outside of most planners' experiences to date. Much greater attention must be given to clients' wants, needs and fears to determine their goals in any post-chapters 11, 12 and 13 landscape. Advisors will, however, need to explain carefully that any contingency planning in which they engage cannot encompass all possibilities.
Testamentary planning to hedge against a possible change in estate tax laws will be an exercise of balancing flexibility against the countless possibilities that can be effected through either a will or a revocable living trust. As an initial matter, testamentary planning has a great deal of hedge benefit over inter vivos planning because competent clients may always change their minds and amend their plans to reflect changing desires.
Some current plans may be fine, as some clients' non-tax planning desires may not be too far from the results of their highly tuned tax planning instruments. For example, a couple might have existing revocable trusts that provide for all property to be left to the surviving spouse in a form that will allow the first decedent's estate to take advantage of the unlimited marital deduction. In that case, the premature death of one spouse before the estate tax repeal would not have any material effect on their plans, assuming that their non-tax desires were the same. Other current plans may include the classic A/B trust or the "three trust" format that has been implemented primarily for tax reasons but which might still be left much in place, even without an estate tax. Aside from the complexity of having multiple testamentary trusts, which is not immaterial, non-tax goals, such as concerns over post-death management of assets or worries about second spouses, might lead clients to decide to leave their assets in one or more trusts.
Some testamentary plans will require amending. Many clients' tax motivated plans are drastically different from those that they would provide absent the transfer tax system. For those clients who wish to hedge, their testamentary documents might be structured to provide contingent dispositions, one to apply if the client dies under the current system and an alternative to apply if death occurs after a repeal. Such a back-up arrangement, put simply, might consist of the following clause:
On my death, I direct my estate to be distributed according to Testamentary Plan A; however, if chapter 11 of the Internal Revenue Code of 1986 has been repealed before, or effective as of, my date of death, then my estate shall be distributed according to Testamentary Plan B.
The back-up arrangement will work if the client dies after any repeal and as long as the legislative change calls for a complete and immediate termination of the transfer tax system. If, however, as is currently proposed in H.R. 8, the legislative change is phased in over a period of time, or if the client wants to plan for the possibility that he or she might die before a repeal but would still like to allow for a post-death modification to his or her plans, drafting will become more complicated. For example, a tax-sensitive approach might be implemented from the date of death forward, only to unwind on the gradual or complete elimination of the transfer tax system.
The terms used to unwind a trust may affect the decedent's estate taxes in a variety of ways under the current transfer tax system. For example, if a QTIP trust provides that it will terminate for the benefit of surviving children on the future repeal of the estate tax, would the decedent's estate be prevented from claiming the marital deduction under Code § 2056(b)(7) because the property might be distributed to someone other than the surviving spouse during his or her life? Providing children or other beneficiaries with a contingent general power of appointment, which is triggered only on the repeal of the estate tax, will probably not prevent a decedent from claiming the marital deduction if the surviving spouse has an existing and noncontingent general power of appointment. Such a structure should not be any different from the situation in which a surviving spouse holds a general power of appointment over a trust and a child holds a limited power of appointment over the same trust, but only to the extent that the surviving spouse fails to exercise such power.
Inter Vivos Planning
Much has been written about the transfer tax benefits of making inter vivos gifts rather than waiting until one's death to distribute wealth. See Jeffrey N. Pennell and R. Mark Williamson, The Economics of Prepaying Wealth Transfer Tax, Part 2, Tr. & Est. 52 (Aug. 1997). Some of these benefits include the tax-exclusive nature of lifetime giving, taking advantage of discounting, removing future growth from the estate and allowing for senior generations to pay the income taxes on those gifts through the defective grantor trust arrangement. Nevertheless, those clients who would not have considered making inter vivos gifts for non-tax motives, whether for the benefit of family members or charity, must reconsider the advisability of large gifts during life. At least one article has raised the issue. See William M. VanDenburgh et al., Should High Net Worth Individuals Still Make Substantial Lifetime Gifts?, 78 Taxes 63 (Jan. 2000).
Although a client might not regret a gift of the applicable credit amount today if the transfer tax system is repealed tomorrow, a gift that results in a gift tax being paid might be seen differently in hindsight. Some clients may therefore decide that the possibility of paying gift tax today is a risk not worth taking. Other clients might believe that the transfer tax system will not be repealed, or that they will not live to see the accomplishment. Therefore, they may still decide that a lifetime gift is appropriate. The vast majority may prefer to hedge lifetime gifts. Is it possible for a client to get part or all of the gifts back if the laws change but still have some benefit should he or she die before a repeal?
Some clients may be satisfied with simply making outright gifts to children or other family members with the hope (but not the understanding) that gift recipients will return the favor if the transfer tax system is ever modified. Family relationships or outside influences on the recipients of gifts, such as spouses, creditors or bad investment decisions, might prevent this from being an advisable solution. Therefore, clients might instead make such transfers in trust, which makes a return of those assets to the grantor more difficult.
One alternative to consider is to make contemplated gifts in trust with a provision that might allow the trust to be unwound on the occurrence of a future repeal in the estate taxes. The two competing interests will be whether the hedge method gives the grantor limited, future access to the trust versus granting access to a third party.
On the other hand, what if the donor's right of revocation or modification is contingent on the repeal of the transfer tax system, which is completely outside of his or her control? Is that contingent power significant enough to prevent the gift from being complete? The answer probably depends on whether such a power may be exercised during life or only on the grantor's death.
Perhaps the closest analogy to whether a contingent power to alter the terms of a trust is permissible is a donor's ability to either add new beneficiaries to an inter vivos trust through procreation, or to change beneficiaries through divorce or remarriage. These powers have generally been held not to be a power to change or designate beneficial interests under Code §§ 2036(a) and 2038 or Treas. Reg. § 25.2511-2(c), or to be an incident of ownership for purposes of Code § 2038 or 2042, because the changes are considered "collateral consequences" of an act that has "independent significance." See also Rev. Rul. 80-255, 1980-2 C.B. 272; Estate of Tully v. United States, 528 F.2d 1401 (Ct. Cl. 1976). In the context of insurance, the power to cancel a group term policy by terminating employment is considered a "collateral consequence" and not an incident of ownership under Code § 2042. See Rev. Rul. 72-307, 1972-1 C.B. 307; see also Estate of Whitworth, 22 T.C.M. (CCH) 177 (1963).
If, however, the grantor can exercise such a right of modification during life, even if counting on estate tax repeal, the power will cause estate tax inclusion under Treas. Reg. § 20.2036-1(b)(3)(iii). "[W]hether the exercise of the power was subject to a contingency beyond the decedent's control which did not occur before his death" is immaterial in determining whether Code § 2036(a)(2) applies. Estate of Farrel v. United States, 553 F.2d 637, 641 (Ct. Cl. 1977). Despite this limitation, a donor may be able to retain a testamentary contingent power to appoint the property under his or her will. This would not fall within the literal scope of Code § 2036.
Arguably, the grantor will also not have any interest in the trust, retained or otherwise, should he or she die with the current estate tax system in place. Therefore, Code §§ 2033, 2036 and 2038 will not apply.
Code § 2037 should likewise not apply. The grantor has not required that possession or enjoyment of the property be subject to surviving his or her death. In addition, while a third party may have the ability to direct that the property in trust be returned to him or her, it cannot be returned to his or her "estate" because the ability to so direct the property would only be triggered on the repeal of the estate tax-when an "estate" would basically be a meaningless term.
The contingent power could even be broad enough to allow the holder to appoint the property to himself or herself. Such a "contingent general power of appointment" should not result in any trust assets being deemed to be owned by the power holder. The holder would not yet have the power, required by Code § 2041(a)(2) and Treas. Reg. § 20.2041-3(b), to exercise at his or her death. Therefore, granting this power, even to the grantor's spouse, may not cause estate tax inclusion.
For those who do not have, or do not trust, a family member or friend to have such a contingent power, the power might instead be given to an independent trustee or trust protector. Although it would be difficult to imagine the independent party exercising such a power, especially when it would operate to divest the existing beneficiaries of any further interest in the trust, it might be possible for the trust to be drafted with enough direction so that the independent party would feel comfortable exercising the power in a manner that clearly carried out the wishes of the grantor, not unlike the contingent grant of a general power of appointment sometimes used for generation skipping transfer (GST) tax purposes. Any such language should be precatory so as to not rise to the level of a direction on the grantor's part, especially if the power may be exercised for the grantor's benefit. The grantor may even attempt to draft a trust that requests future modification for the grantor's benefit on any repeal of the estate tax, but this hope for modification places a great deal of confidence in the abilities of the local judicial system.
Two important things should be noted for contingency planning purposes. First, even if the grantor dies before the fifth year, the appreciation on the proportionate amount of annual exclusions brought back into the estate remains outside of the estate. See Code § 529(c)(4)(C); Prop. Treas. Reg. § 1.529-5(d)(2). Second, and more important for hedging purposes, the grantor may revoke any gifts to a QSTP with only an income tax penalty imposed on the appreciation in the interim. This right of revocation does not cause the assets in the QSTP to be included in the grantor's estate or prevent the initial funding from being a completed gift. Therefore, a grantor could pre-fund his or her entire family's college educations and reduce his or her estate, possibly by a significant amount, with the knowledge that he or she may always access the funds with only a penalty on the growth.
The QSTP could thus be an inexpensive method to hedge for the possible repeal of the estate taxes, as well as an especially attractive method for the moderately wealthy client. Note, however, that there are several drawbacks to this tool. First is the requirement that a QSTP may only be funded with cash contributions. Second, any appreciation is eventually taxed under Code § 72. Another drawback is that a grantor could otherwise pay educational expenses directly without making a taxable gift, instead of using the annual exclusions necessary to fund a QSTP.
All of the possible solutions de-scribed above have some drawbacks, either due to some level of uncertainty or, in the case of a QSTP, the cash funding requirement or income tax results. Some may also consider as a different type of uncertainty the relative youth of the provision and its allowance of the revocation of present interest gifts without estate tax ramifications. It seems too good to be true. For those who wish to provide some assurance that they will be able to reach their assets in post-Chapter 11 days, the options seem relatively safe.
Freeze Planning Techniques Get Hotter
Although the hedging strategies discussed above may offer clients the chance to get back their assets, another critical planning issue is whether to make taxable gifts that result in amounts being paid to the IRS. For some clients, making these gifts will continue to have clear advantages over many other planning options. For other clients who are more likely to live to see what might be changed in the transfer tax laws, paying taxes now to save estate taxes later may ring even more hollow to those clients than it initially does under the current system. For these clients, planning may be best structured in a combination of gifts to take advantage of the applicable credit amounts, or even GST tax exemption amounts, possibly with the above hedging considerations in place, combined with freeze or discount planning.
Some of the more attractive freeze planning options will be for clients to create "preferred partnerships," GRATs or installment sales to defective grantor trusts. Each allows the grantor to potentially shift a large, future increase in value to the next generation, usually with little or no gift taxes being imposed. One excellent choice is to combine the preferred partnership with the installment sale to the defective grantor trust. The grantor trust would be set up to provide for one of the hedge mechanisms discussed above. The grantor trust can also use beneficiary guarantees to reduce or eliminate the normal seed gift requirement. See Milford B. Hatcher Jr. and Edward M. Manigault, Using Beneficiary Guarantees in Defective Grantor Trusts, 92 J. Tax'n 152 (Mar. 2000).
By using the preferred partnership, the grantor is able to convert what may be illiquid or low cash flow assets into a preferred income stream, while still maintaining some degree of asset management and control and providing for lower generation members to become active in the management of the business. If the grantor later chooses to sell the regular partnership interests (the portion of the partnership analogous to the common stock in a corporation) either to the family or to a trust created for their benefit, then he or she would provide for an additional income stream through receipt of a note or cash payment.
Planners may need to review some of the centerpieces of traditional estate plans to see if they are appropriate for clients who wish to plan for transfer tax reform. A young couple may think twice before purchasing an expensive second-to-die life insurance policy and placing it in an irrevocable life insurance trust to provide funding for the payment of estate taxes. Although there are many reasons to purchase life insurance, a policy purchased to pay for estate taxes on the second spouse's death may not always be a prudent investment. Some clients might instead wish to purchase term or convertible term policies to cover such a contingency. Clients who are not charitably inclined should also reconsider creating charitable remainder or lead trusts for transfer tax planning, because most of the benefits would be lost once changes are made to the system.
Advisors should not ignore the chance that the transfer tax system will be repealed, no matter what their own opinions may be. Although the determination of whether clients should try to plan for the possibility of a repeal must be made on an individual basis, their advisors should consider the hedging solutions described in this article.
Edward M. Manigault is an associate with Jones, Day, Reavis & Pogue in Atlanta, Georgia and is a member of the Probate & Trust Division's Lifetime Transfers: Transfer Tax Issues (B-3) and Family Limited Partnerships and LLCs (C-5) Committees.
The views set forth above are the personal views of the author and do not necessarily reflect those of Jones, Day, Reavis & Pogue.