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Wednesday, September 12, 2012

President Obama’s Tax Plan for 2013

Published by the Department of the Treasury in February of 2012, the General Explanations of the Administration’s Fiscal Year 2013 Revenue Proposals (the so-called “Greenbook”) outlines the Administration’s specific policy positions on tax for 2013.  Given the upcoming election and the scheduled sunset of the recently extended Bush-era tax cuts, the 2013 Greenbook takes on particular significance for those individuals and families that are considering estate planning issues.

These proposals can be thought of both as campaign literature (“asking millionaires to pay their fair share”) and as the starting point for negotiations with Congress over the next tax bill.  Thus, while several—or even many—may be enacted to at least some extent, it is unlikely that these proposals will become law in their entirety.  Of course, many of these positions are also somewhat non-partisan as they represent a legislative attempt to stop techniques that the IRS has been unable to stop in court over the course of several administrations.Though the Greenbook is more than 200 pages of detailed tax proposals, the Treasury proposes several specific changes related to estate, gift, and generation-skipping transfer (“GST”) taxes.  Speaking generally, those proposed changes would roll-back tax cuts that were part of the Economic Growth and Tax Relief Reconciliation Act of 2001(“EGTRRA” or, more colloquially, “the Bush tax cuts”) to 2009 rates and attempt to limit the effectiveness of a number of tax-minimization techniques commonly employed by estate planners.

Increase Tax Rates and Decrease Exemption Amounts.  The first proposal, and the broadest, is to raise the rates and lower the exemption amounts of the estate, gift, and GST taxes to 2009 levels.  This would mean a top rate of 45%, exemption amounts of $3.5 million for estate and GST taxes, and a $1 million gift tax exemption.  The Tax Policy Center estimates that under this proposal approximately 7,500 estates will owe estate tax in 2013, as compared to an estimated 3,600 in 2012.  The so-called “portability” of exemption amounts among spouses—allowing unused estate and gift tax exemptions to be used by surviving spouses—would be made permanent.  These changes would result in a significant increase in tax liability for many families as the current top rate is 35% and all three exemption amounts are $5 million each (adjusted for inflation from 2010).  These changes may also increase administrative costs in many instances as a result of the disparity between the gift tax exemption amount and the GST tax exemption amount.

Basis Rules Change.  The next proposal is aimed at the Internal Revenue Code’s basis regime.  In order to understand the Treasury’s position, a brief primer on basic “basis” concepts is necessary.  In an attempt to tax each dollar only once, the U.S. income tax system uses a basis scheme that generally tracks the amount paid for an item.  That amount becomes the basis which is then subtracted from the amount realized in a sale or exchange to determine the taxable amount to which marginal tax rates are applied.  A larger basis means a smaller tax bill.  Gifts generally keep their basis, though it gets adjusted upwards for any gift tax paid.  Bequests (gifts received from estates) get their basis stepped up to the fair market value of the property at the time of death.  This incredibly cursory review of what is, in fact, a relatively complex scheme should lay the groundwork to understand the Treasury’s proposal.

The treasury’s proposal has two components: first, a requirement that recipients of gifts and bequests claim a basis that is consistent with the basis used for gift and estate tax purposes and, second, that donors and executors report this basis amount to both the recipients and the IRS.    As this proposal essentially codifies what taxpayers should be doing anyway, it is not incredibly significant.  The main element is the addition of the reporting requirement, which will not be difficult or costly to fulfill.

Valuation Discount Rules Change.  The third proposal is aimed at the passive investment entities that have been created by families in recent years to manage and transfer their assets.  The Administration would create a new category of “disregarded restrictions” that would not be considered when valuing an interest in a family-controlled entity transferred among family members.  Some background on planning with family entities is helpful.

When families with significant assets—some passive investments, others active businesses—look to manage those assets during life while planning for transfer to the next generation, estate planners frequently turn to custom-made business entities such as partnerships and limited liability companies.  Often, planners impose specific restrictions on these entities and their members that, while inconvenient, are acceptable to or even requested by the participants.  These restrictions are not merely “boilerplate” but, in fact, are fully binding and meant to ensure the financial success of the entity while preserving family harmony—not an easy task.

Besides being functional, these restrictions are also considered by appraisers when determining the value of the entity for tax purposes and can result in what are called “valuation discounts” which reduce the value of the asset for tax purposes from what it would otherwise be.  These discounts are justified because “value” for tax purposes is generally defined as the amount at which property would change hands between two willing parties with neither under any compulsion to buy or sell and both having reasonable knowledge of the facts.  The restrictions used generally lower the amount that a buyer would pay for property, so the value for tax purposes is less.

In transfers among family members, the administration proposes to disregard certain specific restrictions commonly used today including constraints on post-transfer liquidation of the interest in the entity, limitations on a transferee’s ability to become a full partner, and restrictions that would eventually lapse or could eventually be removed by the transferee.  Transfers to non-family members would be valued with the restrictions, however.

GRAT Reform.  Another frequently used planning technique is the target of the Administrations next proposal: the Grantor Retained Annuity Trust (“GRAT”).  A GRAT is a trust in which the trust creator (the grantor) retains an interest that pays out a fixed annual amount (the annuity).  While creation of the GRAT will (usually) generate a taxable gift to the beneficiary, the amount of the gift is reduced by the current value of the annuity which is calculated by subtracting the total value of the annuity payments from the value of the entire trust.  The value of the annuity is adjusted since it will be paid out over time (a dollar today is worth more than a dollar tomorrow) and the trust assets are adjusted based on assumed growth that is tied to the applicable federal interest rate  (“AFR”).  The AFR is an interest rate, published monthly by the Treasury, that is used to calculate interest for tax purposes and currently hovers below 3%.

Any growth in excess of the assumed rate (~ 3%) will be transferred tax-free to the trust beneficiaries.  However, if the grantor fails to survive the term of the trust (which can currently be as short as 2 years), the assets of the trust are included in the grantor’s gross estate for estate tax purposes.  Today, GRATs are a very popular wealth transfer technique since it is relatively easy to beat the growth assumed by the tax code and most people will live well the terms of their GRATs.

The Administration proposes imposing a minimum term of 10 years on all GRATs which would have the effect of increasing the risk that the trust assets would be included in the grantor’s estate.  Also, the administration would require that the remainder interest in GRATs (the value of the trust adjusted for assumed growth less the value of the annuity) be greater than zero.  This is to prevent so-called “zeroed out GRATs” (a GRAT where the adjusted annuity value is high enough to equal the value of the adjusted trust assets) that result in zero gift tax.  It’s not clear, however, if the Administration is proposing some minimum value since gifts of less than $13,000 (the current value of the annual exclusion amount) would be disregarded for gift tax purposes anyway.

GST Exemption Expiration.  The Treasury’s fifth proposal is to limit the duration of the GST tax exemption to 90 years.  While the exact operation of the GST tax is extremely complex, put simply it imposes an additional tax on transfers to “skip persons.”  Generally, those are people that are either more than one generation below the transferor (i.e. a grandchild) or a person, other than the spouse, that is more than 37.5 years younger than the transferor.  Also taxed are subsequent distributions from trusts to those skip persons.  Currently, by using the GST exclusion amount, taxpayers are able to create perpetual (or extremely long-term) trusts funded by up to $5 million that will never be subject to the GST tax.  The administration is proposing a 90 year limit to this exclusion, after which distributions from those trusts will be subject to the GST tax.

Grantor Trust Reform.  The Administration next proposes a modification to what are known as the “grantor trust rules.”  The grantor trust rules, while today used primarily as an estate planning tool, were actually created in the 1940s to counter perceived taxpayer abuse.  Before that time, taxpayers were able to create trusts to shift income to lower brackets without giving up significant control over the assets.  Grantor trust rules attributed the income of trusts containing certain specific control provisions back to the grantor—as if the trust didn’t exist.  The estate tax has similar, but not perfectly co-extensive, rules for inclusion in the gross estate.  Estate planners exploited this delta by creating trusts that were intentionally attributed to the grantor for income tax purposes but not for estate tax purposes. Thus, a grantor would be able to remove assets from their estate and place them in trust for a beneficiary, while also paying the tax generated by the trust during their lifetime.  In this way a trust could grow tax-free.

Seeking to close this perceived loophole, the Administration proposes coordinating the income tax and the estate tax rules on grantor trusts.  Under the plan, if a trust was disregarded for income tax purposes, trust assets would be included in the estate of the grantor.  Also, distributions from the trust would be subject to gift tax.  The benefits of the grantor trust would be virtually negated.

Tax Lien Extension.  The Administration’s final proposal is more of a technical correction. Currently, the Internal Revenue Code allows for a limited deferral of estate taxes in certain circumstances involving the transfer of a small business.  As a condition of this deferral, those assets are made subject to a tax lien that receives the highest priority in bankruptcy and other creditor-related proceedings.  Put simply: the government gets its money first.  That lien currently extends for a term of 10 years while the deferral extends for a maximum of 15 years.  The administration proposes closing that gap and extending the lien through the full term of the deferral.

So what do these proposals mean for you?  At the outset, it’s important to keep in mind both what the Greenbook is and what it isn’t.  The Greenbook isn’t law—yet—so it’s not binding and no doors are closed.  Even if it became the law, which it probably won’t (at least not in its entirety), it wouldn’t affect past transactions.

The Greenbook is, however, a very good indication of what the Administration believes and what the Treasury wants going forward.  In that way it can be thought of as something of a barometer.  How Congress feels about the Administration’s stance isn’t yet clear.  One thing is certain though: there are many powerful estate planning techniques available to taxpayers right now—and at least one branch of government is looking to change that.

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