Monday, February 20, 2012

Obama Budget Proposes to Close Estate and Gift Tax Loopholes

The 2013 Budget Proposal recently submitted by the Obama Administration would return federal estate, generation skipping (GST), and gift taxes to 2009 levels. The top tax rate would be 45 percent and the exclusion amount would be $3.5 million for estate and GST taxes, and only $1 million for gift taxes. In addition, the portability of unused estate and gift tax exclusion between spouses would be made permanent.

If adopted by Congress, the Obama proposals would be effective for the estates of decedents dying, and for transfers made, after December 31, 2012. 

Currently, the estate, GST and gift tax rate is only 35 percent, and each individual has a lifetime exclusion for all three types of taxes of $5 million (indexed for inflation). However, unless Congress and the President can agree, in 2013 the tax rate and tax brackets, the amount of the exclusions and the law governing these three types of taxes will revert to the law that was in effect in 2001 prior to the enactment of the Bush tax cuts of that year.

There will be tremendous pressure on lawmakers to prevent the default reversion of tax rates to 2001 levels. No action by Congress will mean a maximum tax rate next year of 55 percent, plus a 5-percent surcharge on the amount of the taxable estate between approximately $10 million and $17.2 million (designed to recapture the benefit of the lower rate brackets). The exclusion for estate and gift tax purposes would be reduced to $1 million, an 80% reduction from the current level. And there would be no portability of unused exclusions to a surviving spouse.

While most of the public attention will likely be focused on the tax threshold issue ($5 million vs. $3.5 million vs. $1 million), the Obama Administration’s budget  proposes a number of “loophole” closing measures that may be of even greater potential significance to the wealthy. In addition to the decrease from current exclusion thresholds and increase in tax rates, the Obama Administration proposes to put new limits on a number of estate tax reduction devices that are currently in wide use.  The proposals include:

Valuation Discounts.  Estate planners are able to utilize a number of techniques designed to reduce the value of the transferor’s taxable estate and discount the value of the taxable transfer to the beneficiaries of the transferor without reducing the economic benefit to the beneficiaries.

The Administration’s proposal would limit the availability of such valuation discounts by creating an additional category of restrictions (“disregarded restrictions”) that would be ignored in valuing an interest in a family-controlled entity transferred to a member of the family if, after the transfer, the restriction will lapse or may be removed by the transferor and/or the transferor’s family.

Require a Minimum Term of Ten Years for Grantor Retained Annuity Trusts (GRATS). GRATs are a popular technique for transferring wealth while minimizing the gift tax cost of transfers.  A GRAT is an irrevocable trust funded with assets expected to appreciate in value, in which the grantor retains an annuity interest for a term of years. At the end of that term, provided that the grantor has survived, the assets then remaining in the trust are transferred to (or held in further trust for) the beneficiaries. The greater the appreciation in the value of the assets held by the trust, the greater the transfer tax benefit achieved.

Taxpayers have become adept at maximizing the benefit of this technique, often by minimizing the term of the GRAT (thus reducing the risk of the grantor’s death during the term), in many cases to two years, and by retaining annuity interests significant enough to reduce the gift tax value of the remainder interest to zero or to a number small enough to generate only a minimal gift tax liability.

This Administration’s proposal would require, in effect, some downside risk in the use of this technique by imposing the requirement that a GRAT have a minimum term of ten years and a maximum term of the life expectancy of the annuitant plus ten years. The proposal also would include a requirement that the remainder interest have a value greater than zero at the time the interest is created and would prohibit any decrease in the annuity during the GRAT term. This proposal would apply to trusts created after the date of enactment.

Limit the Duration of the Generation-Skipping Transfer Tax Exemption. A generation-skipping transfer (GST) tax is imposed on gifts and bequests to transferees who are two or more generations younger than the transferor. The GST tax was enacted to prevent the avoidance of estate and gift taxes through the use of a trust that gives successive life interests to multiple generations of beneficiaries.

The GST tax is a flat tax on the value of the transfer at the highest estate tax bracket applicable in that year. Each person has a lifetime GST tax exemption ($5,120,000 in 2012) that can be allocated to transfers made, whether directly or in trust, by that person to a grandchild or other “skip person.”

The allocation of GST exemption to a transfer or to a trust excludes from the GST tax not only the amount of the transfer or trust assets equal to the amount of GST exemption allocated, but also all appreciation and income on that amount during the existence of the trust. Because many states, like Pennsylvania, have done away with any limits on the tenure of trusts, GST trusts can now continue, and avoid estate, gift and GST taxation, in perpetuity.

The Administration’s proposal would provide that, on the 90th anniversary of the creation of a trust, the GST exclusion allocated to the trust would terminate.

Place new limits on the use of Grantor Trusts. A grantor trust is a trust of which an individual is treated as the owner for income tax purposes. For income tax purposes, a grantor trust is taxed as if the grantor or another person owns the trust assets directly, and the deemed owner and the trust are treated as the same person. Thus, transactions between the trust and the deemed owner are ignored. For transfer (estate and GST and gift) tax purposes, however, the trust and the deemed owner are separate persons, and under certain circumstances the trust is not included in the deemed owner’s gross estate for estate tax purposes at the death of the deemed owner.

Estate planning attorneys exploit the lack of coordination between the income and transfer tax rules applicable to a grantor trust through techniques like the “intentionally defective grantor trust” that can transfer significant wealth to children or others without gift or estate taxation.   

To the extent that the income tax rules treat a grantor of a trust as an owner of the trust, the Administration’s proposal would (1) include the assets of that trust in the gross estate of that grantor for estate tax purposes, (2) subject to gift tax any distribution from the trust to one or more beneficiaries during the grantor’s life, and (3) subject to gift tax the remaining trust assets at any time during the grantor’s life if the grantor ceases to be treated as an owner of the trust for income tax purposes.

Basis Consistency Requirements. This proposal would help ensure that the basis of the property in the hands of the recipient be no greater than the value of that property as determined for estate or gift tax purposes (subject to subsequent adjustments). 

In order that taxpayers are aware of and use the appropriate basis, a reporting requirement would be imposed on the executor of the decedent’s estate and on the donor of a lifetime gift to provide the necessary valuation and basis information to both the recipient and the Internal Revenue Service.


Of course, taxes are a contentious issue on Capitol Hill and it is quite possible that none of the “loophole” reforms proposed by the Obama Administration will be enacted. However, to the extent that loophole closures can be viewed as distinct from tax increases, we could well see one or more of the above provisions become law.  Depending on what happens politically, we could someday look back on 2012 as the last golden year for wealth transfer opportunities.    

Further Reading

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