Estate Planners Face New Challenges; Welcome to the Renaissance

by Robert Moshman, JD

new age has dawned.¹ Suddenly, all of the lights have turned green for estate-planning techniques. There are new prospects for transfer tax repeal which will place every estate-planning technique in a new light. And if there is to be a carryover basis for assets transferred at death, other techniques, both new and old, will emerge from obscurity and take their place as the new cornerstones of the 21st-century estate plan.

Last year ended with positive developments for two techniques in particular, FLPs and GRATs. Family limited partnerships (FLPs) are on a major winning streak, thanks to several cases, most recently Knight v. Commissioner, and Estate of Strangi. Meanwhile, a trusted old friend, the grantor retained annuity trust (GRAT), had been gearing up for comeback, thanks to a novel "guaranteed GRAT" approach as well as recent Tax Court decisions, one of which, Walton v. Commissioner, invalidated a portion of Treasury Regulations that the IRS had relied upon.

Is this the same profession that watched the IRS and Congress eviscerate one technique after another for the past 20 years? With so many new avenues to pursue and so many new considerations, we are undoubtedly entering a veritable renaissance period for estate planning.² Let's begin by establishing the financial context of 2001.

Triumph of the CLUs

And the winning investment of the new millennium will be...life insurance. Of course, that's an exaggeration; a millennium lasts 1,000 years while tax codes and investment trends have transient lives during which they are continually battered and rearranged by successive tax laws the way waves change and erode the sands of a fragile beachfront.³

But consider the case that can be made for insurance today. The United States economy prepares for a not-so-soft landing after an unusual 10-year expansion. The technology bubble burst last spring and though it may recover on paper, the psychic injury will linger. Not since the Dutch mortgaged their homes to buy tulip bulbs have investors suspended disbelief so thoroughly or been punished as severely.⁴ It will be a long time before investors speculate freely with dot.coms.⁵

Add to this reasoning the current investment context and the dependability of a specific payout being available at a specific time suddenly seems like a stroke of genius. Avoiding the threat of a dot.com crash has value in and of itself.⁶

Life insurance is suddenly the answer for several major reasons: First, as just noted, it is a sure play that will be attractive to disillusioned high flyers who have crashed to earth.

Second, the need for liquidity at death is made evident by the volatility of the market and losses that now exist on paper. Who would feel comfortable selling off stocks from an estate to fulfill pecuniary bequests right about now? Third, peeking ahead about 10 years (or less!), the potential for a carryover basis may increase liquidity needs given the likelihood of capital gains associated with sales during the estate settlement process or aftermath. And finally, the growing and successful usage of second-to-die policies and private split-dollar funding have made life insurance products a critical ingredient in numerous estate plans already. Suddenly, its hip to be square, stodgy, and reliable.⁷

The GRAT's Comeback

The GRAT has suddenly catapulted into the spotlight. By way of background, the GRAT's first cousin, the grantor retained income trust (GRIT), had become very popular during the 1980s prior to the enactment of Chapter 14. But the restrictions imposed on estate freezing left the door open for QPRTs, which are essentially GRITs funded with a principal residence. It was also possible to use GRITs for transfers to persons outside the immediate family.

The GRAT involves a gift of property to an irrevocable trust. The grantor retains an annuity for a term of years. If the grantor survives the term, the remainder of the trust reaches the beneficiaries without additional tax. If the grantor dies during the term, the trust assets are included in the grantor's estate. It has been suggested that a guaranteed GRAT would enable a grantor to sell assets equivalent in value to the reversion interest. In theory, this creates a contractual obligation to transfer assets out of the estate in an amount that offsets the amount of the reversion, causing the additional tax triggered by the reversion to be offset by the amount transferred out of the estate.

Another important issue involved Treasury Regulation �25.2702-3(3) example 5, which the Tax Court ruled to be erroneous in Walton v. Commissioner in December, 2000. An annuity is a qualified interest under �2701 and can easily be distinguished from a contingent remainder. Note also that while the Tax Court has the last word for the moment, the IRS is not known to be a gracious loser. How far exactly the door is opening for GRATs must be explored at length in the near future.⁸

A Leading Role for FLPs

The Tax Court has continued to uphold family limited partnerships (FLPs) over the objections of the IRS, but it was not a unanimous decision. During the waning days of 2000, the Court found that transfers were gifts of partnership interests and not of the underlying assets because the partnership was a valid and enforceable entity. Several court positions should be noted:

The creation of an FLP was not a taxable gift in its own right. The fact that a taxpayer transfers assets only months prior to death is not relevant, at least not where imminent death was not anticipated.

Lack of economic substance was not a successful argument on the part of the IRS, but several Tax Court judges sided with the IRS on this point.

Discounts for marketabilty and minority interests were provided, but the IRS valuations have been heeded by the Tax Court.

Note that in the recent case of Strangi, the taxpayer possessed a 99% limited partnership interest and 47% of the 1% general partnership share. A 99.47% owner may lack the legal right to control the partnership where 53% of the general partnership's 1% share is not controlled by the taxpayer. However, the Court did not fully address this issue only because it was not raised in a timely manner.⁹

Anticipating the Carryover Basis

The Death Tax Elimination Bill of 2000 that was vetoed by President Clinton last year would have repealed the estate, gift, and generation-skipping transfer taxes. In a world without estate tax, staples of today's basic plan such as credit shelter trusts, qualified terminable interest trusts, and GST tax-exempt trusts would no longer have the same tax relevance.

It is not clear whether the Bush Administration will support the carryover basis component that was included in each of the two estate tax repeal proposals that his predecessor in office had vetoed. Some may recall that we have been down this path once before.¹⁰ Note that the 1971 repeal of Canada's estate tax also coincided with the adoption of a carryover basis for assets passed at death. Although the carryover basis has been linked to the repeal of the American estate tax as though it is a necessary counterpoint, the replacement of lost tax revenues is not the predominant concern.¹¹

The most recent proposal would have provided a stepped-up basis exemption for $1.3 million for assets passing to any individual and $3 million for assets passing to a spouse. Exemptions at these levels would certainly shield many estates from the complexities of the carryover basis calculations.

In much the same way that a credit shelter trust designates assets that will be available to take advantage of the unified credit under the current law, a stepped-up basis exemption shelter trust could be useful in keeping highly appreciated assets available for the new exemptions.

The designation of assets for such a trust would have to be coordinated with other strategies. Some appreciated assets will remain in a family forever and would therefore be unlikely to benefit from a stepped-up basis. Other appreciated assets might be useful in making a charitable gift and the tax savings and priorities involved in the different transfers would have to be weighed. In a smaller estate, full funding of a stepped-up basis exemption trust could leave insufficient assets for other purposes.

On the other hand, many estates need to be more concerned about a carryover basis than with estate tax. Fewer than 2% of estates now have estate tax liability, while virtually every estate has appreciated assets. Using data from the Survey of Consumer Finances, economists James Poterba and Scott Weisbenner concluded that unrealized capital gains make up 37% of the value of estates exceeding $1 million and about 56% of estates worth more than $10 million.

A married couple would have to prepare for three exemptions totaling $5.6 million of appreciated assets: The $1.3-million exemption of the first spouse to die, the $3 million stepped-up exemption for assets transferred to a spouse, and the $1.3-million exemption of the surviving spouse. With an assumed capital gains tax rate of 20% and a zero cost basis, those assets would result in a potential capital gains tax liability of $1.12 million upon the future sale of the assets. However, for assets held more than five years and acquired after December 31, 2000, a top capital gains tax rate of 18% would apply.

State Death Tax Jamboree

The state death tax credit in the current tax code has prompted every state to enact a tax in the exact amount of the federal estate tax credit that is provided for that purpose. As a result, taxpayers pay no additional tax, yet every state is able to siphon off tax revenues that would otherwise have go to the Federal Treasury.¹²

With the potential end of the Federal estate tax, states would have the opportunity to enact their own tax arrangements. Some may want to merely make up for lost revenues. Others may want to exploit the absence of Federal tax to impose a higher tax burden and claim more for the state than before. Some states may compete to become estate tax havens to encourage the flow of intangible assets into their own state's economy. Should transfer tax repeal arrive on the books, states inclined to protect their revenues may not wait for the full phase-in of the repeal to carve out an alternative estate or inheritance tax.

The Future Is Now

Cosimo de Medici Bush, apparently a patron of the modern Renaissance in estate planning, may soon follow through on the elimination of transfer taxes. Whether the phase-out is completed or the carryover basis is implemented remain huge uncertainties that may not be resolved for years to come. But with the advent of new estate-planning tools and a new time in history, it is the most fascinating and dynamic period estate planning has enjoyed in many a year.

Robert Moshman, JD, can be reached at bmoshman@optonline or (800) 572?2468 with any questions, comments or suggestions. He authors the Estate Analyst.

References

¹ Once and for all, the real millennium started January 1, 2001 and if armageddon missed us on both 12/31/99 and 12/31/00, then you can probably start using up that stockpile of canned goods.

² The Renaissance, stretching from 1350 to 1650 AD, was a period of change and achievement. It was the rebirth of civilization that followed the Middle Ages and led to our modern age. Art, architecture, commerce, music, science-the well-rounded "Renaissance Man" made progress on every front, in every discipline. Everything was revitalized and reexamined from a broader perspective. Today, the estate-planning niche is being reinvented and the estate-planning professional is called upon to provide multi-disciplinary expertise. Though planners have long focused on transfer tax avoidance, the rules of the game are now changing. Just as Leonardo da Vinci broke new ground in painting the enigmatic Mona Lisa in 1503 (during the High Renaissance) with depth of perspective and emotional content that changed the direction of art history, so too must modern day Leonardos take leave of the must-reduce-estate-tax mindset and the unidimensional credit shelter-QTIP-GST-Crummey-Dynasty menu of options.

³ Tax-writing committees need to justify their existence and each new Congress wants credit for tax reforms. There is also the cat-and-mouse process of taxpayers finding loopholes and lawmakers attempting to close them which makes instability the rule and consistency the exception. As a result, the tax code has grown from 100 pages in 1930 to 2,840 pages today, and the major components of our tax system are not as well established historically as one might assume. The coordination of estate and gift taxes in a unified system is 25 years old. The generation-skipping transfer (GST) tax is 15 years old. And the estate tax, seemingly an unassailable fixture of imponderable age, has in fact been repealed on three previous occasions. The current version has been with us since 1916.

⁴ Tulip Mania swept 17th-century Holland and remains the model for a speculative investment craze gone bad. However, it took a lot longer for the bubble to burst on tulip speculation. In 1610, a single tulip bulb served as a dowry for a bride. Yet the "mania" took another 25 years to peak between 1633 and 1637. Then, like Japanese real estate and the dot.coms, the bottom fell out of the tulip market and many Dutch families were financially ruined.

⁵ The Nasdaq as a whole fell more than 50% from a high in March to the low at which 2000 ended, yet there were many Internet stocks that were down 90% during that time period. Serious job cuts began in March, and companies started to fold-17 Internet companies called it quits in October alone. Venture capital moved on. Executives demanded cash, not stock options. One day in May, Boo.com was gone without so much as a boo. By August, Pop.com's backers reconsidered and...pop went the planned launch. Planet-Outdoors.com's stock price dropped from $163 to $11 in about six months. Furniture.com lost $664 million in one quarter and locked the door. The dot.com infirmary saw DrKoop.com and WebMD, while Priceline.com, CareerBuilder.com, Autoweb.com, and hundreds more fell to earth as the bubble burst. Not all survived the fall. Meanwhile, Phone.com and Software.com slipped out of their negative dot.com names and merged under a safer new name, Openwave Systems. How 1980ish.

⁶ Liquid assets arriving just in time (at death) and in just the right amount (pre-established) to finance a buy-sell agreement, satisfy bequests, pay off mortgages, satisfy debts and taxes...what a great idea. First sliced bread, and now, life insurance.

⁷ Will insurance become a commodity sold over the Internet while former agents get broker's licenses and lament the devaluation of their CLU certifications? That projection may have made sense during the last millennium, but in this Renaissance, Internet companies such as MyCFO.com that can aggregate client information to one location while other sites are providing investment-planning services that are more and more automated. Technology is also enabling investors to essentially "roll their own" customized mutual funds. Where in the world will human beings find a value-added service? Possibly a flesh-and-blood financial planner who knows something about the new best game in town, life insurance.

⁸ Walton v. Comm'r, 115 TC ___ No. 41 (Dec., 2000); and Cook v. Comm'r, 115 TC 15 (2000). Handler and Dunn, Guaranteed GRATs: GRATs without mortality risk, 138 T&E 13, p. 30 (Dec., 1999)(See also Handler and Oshins, GRAT remainder sale to a dynasty trust, on page 20 of the same December, 1999 issue of Trusts & Estates). In, Running the numbers: An economic analysis of GRATs and QPRTs, ALI-ABA Estate Planning Course Materials Journal (Aug., 2000), Lawrence Katzenstein concluded that Example 5 of Treasury Reg. �25.2702-3(3) incorrectly interprets the statute and foresaw the Tax Court's decision.

⁹ Knight v. Comm'r, 115 TC ___, No. 35 (Dec., 2000); Estate of Strangi, 115 TC ___, No. 35 (Nov., 2000); Church v. U.S., 85 AFTR2d 2000-804 (W.D. Tex., 2000); Estate of Harper v. Comm'r, TC Memo. 2000-202 (2000); and Kerr v. Comm'r, 113 TC 449 (1999).

¹⁰ The Tax Reform Act of 1976 would have converted America to a carryover basis, but the effective date of the law was postponed in 1978 and then repealed retroactively by the Crude Oil Windfall Profit Tax Act of 1980. Some of the problems that proved daunting in the late 70s involved the administrative task of calculating the original cost basis for a large and diversified portfolio. Modern information systems have simplified these burdens. Other problems remain. Computers are no help in ascertaining the original cost basis for assets that were purchased many years ago and for which no records were retained. It is also conceivable that an individual's estate could contain one property that is inherited from a first parent to die with a cost basis, another property from that parent that has a stepped-up basis, and then additional properties from the surviving spouse.

¹¹ Budget surplus projections increased from $4.2 trillion to $5 trillion over the next 10 years making tax cuts relatively guiltless. Moreover, the Congressional Budget Office estimated that, even with the $3-million and $1.3-million stepped-up basis exemptions, a carryover basis may only generate sufficient revenues to replace about 12% of the lost transfer tax revenues...and those were small to begin with. But see www.cbpp.org/1-4-01bud.htm.

¹² The tax has become colloquially known as the "sponge tax" or in some parts of the country as a "pick-up tax" or "sop tax" because it picks up or sops up the amount allowed by the state death tax credit under "2011. About 20 states already have their own estate and/or inheritance taxes as well.

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