Estate Planning in 2010 and Beyond May 20, 2010 Prepared by: Stephanie G. Rapkin, Esq., Mequon, WI Beth D. Tractenberg, Esq., Partner, Katten Muchin Rosenman LLP, New York, NY

2 Introduction - ABA Letter "Although basis and gain are by themselves not new concepts, the institution for one year of a carryover basis regime to replace the estate tax in 2010 is a challenge.“ Carryover basis is not well understood. The carryover basis regime will apply to more taxpayers than the most recent estate tax did. Planning in 2010 has either stopped because no one knows what to do, or is proceeding frantically to cover all possible outcomes in an environment in which no one knows what works. The possibility that Congress may reinstate and change the estate and GST taxes retroactively increases the difficulty of making an effective plan. The dilemmas are not limited to "

3 Carryover Basis Step up in basis is a concept which has been part of the code since Carryover basis upon death is something that Congress has played with before. In 1976, it was believed that step up in basis discriminated against those who sell property prior to death as compared to those who didn't sell. An estate tax was still imposed. Today, the motivation behind the elimination of step up in basis was to replace the estate tax in its entirety.

4 Background and History of Section 1023 Section 1023 was passed in 1976, it was delayed to be effective January 1, It was subsequently repealed by Section 401 of the Tax Act in 1980, just one month after its implementation, with such repeal being retroactive. The law provided that property acquired from or passing from a decedent was to have the decedent's basis on the date of death with certain adjustments. Basis could be adjusted by estate taxes paid. Estates would also get a minimum adjustment of basis up to $60,000. In general, the subsequent sale of such property was to be characterized as ordinary income.

5 Background and History of Section 1023 Cont. This provision was deemed totally unworkable. The carryover basis provisions had caused a significant increase in the time required to administer an estate and resulted in raising the overall cost of administration.

6 Background and History of Section 1022 Section 1022 was part of the 2001 Economic Growth and Tax Relief Reconciliation Act. The objective was to eliminate the estate tax system. This is a one year provision for 2010, and only It was only a one year provision because of budget constraints.

7 Background and History of Section 1022 Cont. Affects more individuals than the previous estate tax and less wealthy individuals as well. May result in very unequal treatment of heirs. Both were probably unintended consequences.

8 Current Provisions of 1022 of the Code Basis. Property acquired from a decedent who dies in 2010 shall be treated as though received by gift from the decedent. See Sec. 1022(a)(I). Basis shall be the lesser of: (1) the decedent's adjusted basis; or (2) the fair market value of the property on date of death. See Sec. 1022( a)(2)(A)(B). Note: As a result of the "lower of' rule, if death is expected to occur in 2010, consideration should be given to selling assets with a built-in loss to avoid losing use of the loss. Note: The effect of these provisions is that, in general, there is no step-up in basis for assets received from a decedent in However, there are limited new special basis allocation rules.

9 Current Provisions of 1022 of the Code Cont. 2. Basis Increase. Basis maybe increased by $1,300,000 which may be allocated by the Executor to property received by any recipient. See Sec. 1022(b )(2)(B). a. The $1.3 million basis adjustment does not apply to the following property as it does not fall within the definition of "acquired from a decedent": (a) Property that would have been included in the decedent's estate under Secs. 2035, 2036, 2038 or (b) Property included in the decedent's estate under Sec as a result of a QTIP election; and (c) The basis adjustment also cannot be applied to property acquired by the decedent by gift within 3 years of his date of death unless it was acquired from his spouse.

10 Current Provisions of 1022 of the Code Cont. b.Community property is an exception to the "owned by the decedent" rule. An executor may allocate the decedent's basis to both the decedent's and the surviving spouse's interest in community property. Jointly held property between spouses will be assumed to be 50% owned by the decedent. Ownership interest may be adjusted if can show decedent provided more consideration. See Sec (d) (1)(b)(I). c.A beneficiary who acquires a decedent's principal residence as carryover basis property can also use the decedent's $250,000 gain exclusion under Sec Note: Sec.1022(b)(3) provides that a non-resident, non-citizen decedent, the basis adjustment is only $60,000 - not $1,300,000.

11 Current Provisions of 1022 of the Code Cont. 3. Spousal Basis. An additional $3,000,000 of step-up may be allocated to "qualified spousal property" received by a surviving spouse. See Sec. 1022( c)(1). a. "Qualified Spousal Property" means: (a) outright transfer property and (b) qualified terminable interest property. See Sec.1022(c)(3)(A) and (B). b.A general power of appointment trust does not qualify. Note: Sec. 1022(c) provides its own definition and does not refer to Sec c.No differentiation is made between citizen and non-citizen spouses as to allocation of the $3,000,000 of basis "step up". Thus, death in 2010 may provide a significant benefit to a surviving non-citizen spouse, as she may receive property free from tax with no requirement of a Qualified Domestic Trust and will receive a step-up on par with a U.S. Citizen surviving spouse.

12 Current Provisions of 1022 of the Code Cont. Pecuniary Bequests. Pecuniary bequests receive a carryover basis, however, the basis in the hands of the recipient may be adjusted by the gain recognized by the estate on the difference between date of death value and distribution date value. There is a similar rule for pecuniary distributions from certain trusts. Thus, if a decedent's will gives A a cash legacy of $10,000 and the executor makes a distribution of X stock to satisfy the legacy with a basis of $4,000, a date of death value of $9,500 and a date of distribution value of $10,000, the estate will recognize gain of $500 and A's basis for the stock would be adjusted to $4,500 (the carryover basis and recognized gain). See Sec

13 Current Provisions of 1022 of the Code Cont. The holding period is no longer the decedent's holding period. Thus acquired property is no longer automatically long-term gain property.

14 Current Provisions of 1022 of the Code Cont. 1022(d) (2) provides for reporting the basis adjustment on a return (as yet to be created by the Secretary). The report is to have: 1.The name and EIN of the recipient of the property; 2. An accurate description of the property; 3. The adjusted basis of the property on date of death and the fair market value on date of death; 4. The holding period of the property; 5. Information which would indicate whether a subsequent sale would get treated as ordinary income; and the amount of basis allocated to the property.

15 Current Provisions of 1022 of the Code Cont. The return is due with the decedent's income tax return or a date as set in the yet unwritten regulations. The failure to file the statement/form/report results in a $10,000 fine. Each beneficiary who receives assets other than cash must be given a statement within 30 days containing the above information. Failure to provide the statement results in a $50 penalty as to each beneficiary who failed to receive such a statement. There is a reasonable cause exception, but intentional disregard has a 5% of FMV penalty. Presumably overvaluation penalties under Section 6662 will also apply.

16 Current Provisions of 1022 of the Code Cont. Who can make the allocation? Code uses the term "executor". Query can the trustee or another person in control of the property have this authority? The Joint Committee's explanation of the provision does provide for a Trustee to make the report to the IRS.

17 Current Provisions of 1022 of the Code Cont. The allocation is made on an asset by asset basis. To whom and to what assets do you make the allocation? For example, heirs who receive bequests might get the basis allocation while residuary beneficiaries get none of the allocation. The conflict is not only within the group of beneficiaries, but may also include a trustee/executor who is also a beneficiary. Executor has duty of loyalty and a duty of impartiality.

18 Midyear Repeal The options are: 1) repeal retroactively [Jan 1,2010] (there is precedent for this - i.e. the 1980 Act did it); 2) repeal on a date new legislation is published [for example: June 1,2010]; 3) repeal only carryover basis - no tax at all in 2010; OR 4) Congress may also do nothing.

19 Constitutionality Issues of Repeal There are a number of cases upholding retroactive tax legislation. The key is showing that there is a legitimate legislative interest.

20 Adapting Estate Plans for 2010 A.GST Issues 1."Had Never Been Enacted" Rule. a. Issue: Section 2664 of the Code provides that chapter 13 shall not apply to generation-skipping transfers ("GSTs") after December 31, A second "had never been enacted rule" is part of Section 901 of EGTRRA which provides that the IRC shall be applied and administered to GSTs that take place after 2010 as if EGTRRA, including IRC Sec. 2664, had never been enacted. These two "had never been enacted rules“ have created an extremely uncertain GST environment. Section 901 of EGTRRA reads (in part) as follows: "Section 901 Sunset of Provisions of Act. a. IN GENERAL. All provisions of, and amendments made by, this Act shall not apply... (2) in the case of title, V, to estates of decedents dying, gifts made, or generation skipping transfers, after December 31, b. APPLICATION OF CERTAIN LAWS. The Internal Revenue Code of shall be applied and administered to years, estates, gifts, and transfers described in subsection (a) as if the provisions and amendments described in subsection (a) had never been enacted.”

21 Adapting Estate Plans for 2010 One important note is that chapter 13 is still part of the Code - IRC Sec and Sec. 901 of EGTRRA merely provide that the Code does not apply to GSTs in 2010 (it still applies, for example, with respect to recalculating an inclusion ratio for transfers to a trust during 2010).

22 Adapting Estate Plans for Basic Questions Resulting From Rule. The "had never been enacted" rule of Section 901 ofEGTRRA clearly means that the helpful provisions of EGTRRA, including the qualified severance provisions and (depending on your perspective) the automatic allocation of GST exemption to a transfer to a GST trust will no longer apply. Not clear are the answers to the following questions regarding application of the "had never been enacted" rule:

23 Adapting Estate Plans for 2010 a. Should we apply the GST after 2010 as if the estate tax and the GST tax had been applicable in 201O? Does the "had never been enacted rule" mean that in determining the GST significance of events that occur beginning in 2011, we must pretend that the estates of 2010 decedents were subject to the estate tax and that 2010 GSTs were subject to the GST tax? Assume that a Will of a decedent who dies in 2010 creates and funds a trust. That trust will not hold property that was subject to an estate or gift tax. Does the trust have no transferor or does application of the "had never been enacted" rule mean that we pretend that an estate tax was imposed so that the trust does have a transferor?

24 Adapting Estate Plans for 2010 b. Must we change the GST attributes of a trust that acquired those attributes as a result of provisions of chapter 13 added as part of EGTRRA? Many trusts have taken advantage of some of the helpful provisions of EGTRRA and questions remain as to whether these trusts will be required to adjust their inclusion ratios to what they would have been had EGTRRA never been enacted. For example, if a trust was severed pursuant to a qualified severance and such provision is to be deemed to have not existed, will the trusts be reconnected after 201O? Or, what if a trust is created in 2007 and GST exemption was automatically allocated to the trust under the automatic allocation rules of EGTRRA? Will the trust be treated in 2011 as if there had been no GST exemption allocated to the trust (because clearly there would have been no allocation of GST exemption made if EGTRRA had never been enacted).

25 Adapting Estate Plans for Specific questions for GST transfers in 2010: a. May GST exemption be allocated? It seems not, as there is no GST tax and no GST exemption in 2010

26 Adapting Estate Plans for 2010 b. Will GST exemption be automatically allocated to a "direct skip" transfer? It is unclear. Either (i) the transfer is not treated as a direct skip and is ignored or (ii) in 2011 we act as if EGTRRA had never been enacted and then treat Sec. 2632(b) as if it had applied to direct skips in 2010 and thus GST exemption was automatically allocated to the 2010 direct skip

27 Adapting Estate Plans for 2010 c. Will a 2010 transfer to a trust with an inclusion ratio of less than one require a redetermination of the trust's applicable fraction if the transfer is not a direct skip? Yes. Sec. 2642(d) requires that a trust's applicable fraction be redetermined when property is added to it. The "had never been enacted" rules would require redetermination even as a result of 2010 transfers.

28 Adapting Estate Plans for 2010 d. Will the "move down" rule of Sec. 2653(a) apply in 201O? No. It cannot apply if there is no GST tax. After 2010, it is unclear how it would apply. If the "move down" rule applies after 2010 as if 2010 transfers were subject to GST tax, it should apply to a trust holding property with respect to which there was a 2010 taxable distribution to a skip person, trust or a taxable termination that did not result in an outright distribution of property. But if 2010 GST transfers are treated as if chapter 13 did not apply in 2010 despite the "had never been enacted" rule, the "move down" rule would not apply.

29 Adapting Estate Plans for 2010 e. What if a death occurs in 2010 and the decedent's will creates a trust with assets that would have been includible in his gross estate if he had died in a year other than 201O? Will the trust be subject to GST tax after 2010? The transfer in 2010 is not subject to estate tax and so it would seem that there would be no transferor for GST purposes because the transfer was not subject to estate or gift tax. Thus, a reasonable conclusion would be that the trust would never be subject to GST tax. However, if the proper interpretation of the "had never been enacted' rule is that we pretend that estate tax was imposed in 2010, transfers out of the trust to skip people would be subject to GST tax.

30 Adapting Estate Plans for 2010 Many documents have formula clauses for distribution. Many formulas will have no meaning or will result in all passing to marital or bypass trust. A number of states have proposed or enacted legislation which provides that in documents with marital deduction formulas/provisions are to be interpreted as they would be if the law was as it was in Modifications must be made to whatever type of formula clauses so as to not underfund the marital share particularly in a modest estate.

31 Adapting Estate Plans for 2010 Disclaimer trusts are still a viable option. Must be regular marital trust or Q-TIP, but cannot be Power of Appointment Trust. What is ideal is dependent on client's situation - their desires, their age and health. Current basis of assets is also an important consideration

32 Adapting Estate Plans for 2010 C. Planning for Sales of Property The consensus is don't sell property in The exception is if there is a loss and death is imminent.

33 Adapting Estate Plans for 2010 There are many methods for drafting the allocation clause but questions need to be asked. –Should bequests get first allocation dollars vs. residuary? –Should certain type of assets such as business assets vs. capital gain assets get the allocation? –Should consideration be given to the tax brackets of heirs? –Should low basis assets vs. high basis assets be given priority? –What happens if basis can't be established? Regardless of these decisions may want to draft documents to hold the executor/trustee harmless for such decisions.

34 Adapting Estate Plans for 2010 E.Gifting: This is a good time to make gifts. Under amended IRC Sec the top rate of tax will be 35 percent, which corresponds to the top rate of income tax. The 35 percent rate applies to gifts over $500,000. For amounts below $500,000, the rate schedule in IRC Sec is the same as in IRC Sec Remember that one million is still exempt from gift taxes. However, if repeal occurs, the rate may return retroactively to 45%. Very good time for GRATS, QPRTs or other gifting techniques.

35 Adapting Estate Plans for Gift Tax Completion Rule: New IRC Sec 2511 applies to gifts made after December 31, Concerns about this rule may be overstated. New Sec. 2511(c) provides that "a transfer in trust shall be treated as a transfer of property by gift, unless the trust is treated as wholly owned by the donor or the donor's spouse." Many practitioners were concerned that it would be impossible to use GRATs or other intentionally defective grantor trusts for gift planning in 2010 because Sec (c) would render transfers to such trusts incomplete for gift tax purposes. However, IRS Notice 2010 attempts to alleviate these concerns. It is now widely thought that the new Sec (c) will not prevent transfers to most grantor trust (e.g., GRATs and ILITs from being completed gifts. Query: given the language of Sec (c), can clients purposefully make transfers to grantor trusts and take the position that they have not made taxable gifts?

36 Adapting Estate Plans for Testamentary Charitable Gifts. Gifts to charity whether in trust or outright upon death have no tax advantage. Much better planning is to leave all assets to family members who can then transfer the assets to charity and take an income tax deduction.

37 Adapting Estate Plans for 2011 The temporary measure of the 2001 tax act means that in 2011 (Jan. 1) we return to the law as it was on December 31, 2000 and via the Taxpayer Relief Act of 1997 to the year The applicable exclusion is $1 million with a tax credit of $345,800. The lowest rate will be 41 % while the highest estate and gift tax rate will be 55% (60% in some cases on limited amounts with a 5% marginal surtax on estates over $10 million up to $24 million). The GST exemption will revert back to $1,000,000, but will be adjusted upward for inflation which brings it to $1,340,000 in The gift tax exemption will continue to be $1,000,000. In addition, the credit under Section 2011 for state estate and inheritance taxes will return (as will Section 2014 the credit for foreign death taxes).

38 Adapting Estate Plans for 2011 Other Applicable Provisions for the year Section 2057 Family Owned Business Exemption returns. Section 2057 provides for an additional $675,000 of an estate tax exemption. Extension of Time to Pay Taxes Returns and Closely Held Business Interests Section 6166 returns. The number of owners of a closely held business to qualify for Section 6166 will now be 15. Sections 2011 and 2013 return.

39 Adapting Estate Plans for 2011 Back to Estate Tax Planning Techniques GRAT/QPRT/PRT Reducing the estate tax through the use of a split interest mechanism which involves leveraging a gift. Currently there is a bill in the House (H.R. 4849) which provides that the minimum length of time for a GRAT is 10 years and would preclude the use of zeroed out GRATS.

40 Adapting Estate Plans for 2011 Installment Sales to a Defective Trust. Use of a defective trust to freeze the appreciation and maintain an income stream while offsetting the estate tax with gifting. *All of these techniques are fully explored and discussed in the treatise "Planning for Large Estates" published by Matthew Bender (a subsidiary of Lexis).

41 Adapting Estate Plans for 2011 Scins. Classic estate freezing technique which eliminates the sellor's appreciation results in an income tax at a lower rate than the estate tax

42 Adapting Estate Plans for 2011 Charitable Remainder Trusts. Used to reduce overall estate taxes while carrying out donative intent.

43 Adapting Estate Plans for 2011 Valuation Discounts. Adjustments in fair market value of a transfer of assets based on a of factors.