Our annual estate and tax planning newsletter discusses certain concepts and techniques that should be considered in 2022 by our clients and friends in California. Perhaps the most important recent development was the failure of the Democrats (no Republicans supported this legislation) to enact President Biden’s “Build Back Better” proposal using the “Budget Reconciliation” process that does not require any Republican votes. President Biden has indicated his desire to enact that legislation in 2022, which could include a series of sweeping tax changes as outlined below.
1. Brief Summary of Some Biden Tax Proposals. The Democrats are considering changes to the Internal Revenue Code to support President Biden’s “Build Back Better” spending plan. The following potential developments may affect your present estate plan. The legislative outcome is not yet clear, and passage may depend on compromises that result in an affordable and honestly accounted plan that narrows the spending priorities. Any tax changes enacted in 2022 could have retroactive effect, again making estate planning this year much more complicated.
A. Estate and Gift Tax Exclusion Amount: Effective January 1, 2022, the 2021 federal estate and gift tax $11,700,000 lifetime exclusion is increased to $12,060,000. New legislation may accelerate the sunset provision (i.e., roll-back) currently scheduled to cut the exclusion in half in 2026. In the face of the potential of reduced lifetime exclusion amounts for estates and gifts, donors may consider lifetime gifts this year totaling up to $12,060,000 ($24,120,000 for a married couple). No reductions were included last year in either of the House or Senate Bills.
B. Grantor Trusts: The new legislation may include changes to the taxation of grantor trusts (trusts over which the grantor retains certain powers over trust assets causing the grantor to be subject to taxation on trust income). Such provisions were included in the House Bill but not in the Senate Bill. This may affect which, if any, grantor trusts will remain as viable estate planning vehicles for individuals. It is likely that any such changes will be effective on the date of enactment and that grantor trusts currently in existence will be grandfathered in whole or in part under any new law. These grantor trusts include grantor retained annuity trusts (GRATs), intentionally defection grantor trusts (IDGTs), qualified personal residence trusts (QPRTs), irrevocable life insurance trusts (ILITs), and others.
C. Stepped-Up Basis: There is a concern that new legislation might eliminate the stepped-up basis available when a taxpayer dies, although neither the House Bill nor the Senate Bill so provided last year (see paragraph 11).
D. “High-Earners” and Roth IRA Conversions: One proposal eliminated conversions of traditional IRAs to Roth IRAs for taxpayers whose incomes exceed $450,000 filing jointly, $400,000 for single taxpayers, and $425,000 for taxpayers filing as heads of household, effective for tax years after December 31, 2031. All taxpayers would be unable to convert after-tax money held in an IRA or qualified plan to a Roth account (a so-called “back-door” Roth conversion) under another proposal.
The discussion below assumes that none of the foregoing proposals is enacted.
2. Transfer Taxes. The major changes made in 2010 in the law regarding gift, estate, and generation-skipping transfer (“GST”) taxes (collectively, “transfer taxes”) are now permanent, although any new Congress could amend them. The 2018 Tax Act provided for an increase in the transfer tax exemption from $5,000,000 to $10,000,000 (indexed for inflation) until after 2025.
A. Gift Tax: The tax-free “annual exclusion” amount has increased to $16,000 in 2022. The cumulative lifetime exemption increased to $12,060,000 in 2022 until after 2025 (indexed for inflation). The tax rate on gifts in excess of $12,060,000 remains at 40%.
B. Estate Tax: The estate tax exemption (reduced by certain lifetime gifts) also increased to $12,060,000 in 2022 until after 2025 (indexed for inflation), and the tax rate on the excess value of an estate also remains at 40%. All of a decedent’s assets (other than “income in respect of a decedent,” such as IRAs and retirement plan benefits), as well as a surviving spouse’s half of any community property assets, still will have an income tax basis equal to the fair market value of those assets at the date of death [“stepped-up (or -down) basis”]. In this regard, securities brokers still are required to retain basis records and report the income tax basis of securities to the IRS. Accordingly, be sure to advise your broker of your basis in securities received by gift or inheritance. In addition, Executors must report the basis of an inherited asset as shown on the federal estate tax return to the IRS and to the beneficiary of the asset.
C. GST Tax: For 2022, the GST tax rate also remains at 40% and the lifetime exemption also has increased to $12,060,000 in 2022 until after 2025 (indexed for inflation). Paragraph 8 includes more information about the GST tax.
D. Portability of Estate Tax Exemption: The “portability” rules provide for the transfer of a deceased spouse’s unused estate tax exemption (“deceased spousal unused exclusion amount” or “DSUEA”) to a surviving spouse (without inflation adjustments). Thus, if a 2022 decedent’s taxable estate is not more than $12,060,000, the DSUEA can be used in the future by the surviving spouse with respect to both gift taxes and estate taxes (but not GST taxes). Portability is not available if either spouse is a nonresident alien. Portability will allow some couples to forgo a more complex estate plan while still taking advantage of both spouses’ transfer tax exemptions. Portability must be irrevocably elected on a timely filed (including extensions) estate tax return, even if a return is not otherwise required to be filed.
A typical estate plan for a married couple generally has provided for the establishment of two (or three) trusts at the death of the first spouse: A revocable “Survivor’s Trust;” an irrevocable “Residual (or “Exemption” or “Bypass” or “Credit Shelter”) Trust;” and possibly an irrevocable “Marital (or “QTIP”) Trust.” One of the reasons for the Residual Trust is to use the deceased spouse’s estate tax exemption to the fullest extent possible. Under the portability law, however, if one spouse dies and leaves assets to persons (other than the surviving spouse and charity) in an aggregate amount less than the basic exclusion amount ($12,060,000 in 2022), the surviving spouse in the future may be able to use the DSUEA as well as the surviving spouse’s own exemption for gift and estate (but not GST) tax purposes.
This portability provision may eliminate the need to create an irrevocable “Residual Trust” at the first spouse’s death. For example, if this year the first spouse to die leaves all of his or her assets to the surviving spouse, no part of the deceased spouse’s exemption is used because of the marital deduction available for assets passing to a citizen surviving spouse at the first spouse’s death. Unless the surviving spouse remarries and survives his or her new spouse, he or she will have an aggregate exemption of (i) $12,060,000 (DSUEA) and (ii) his or her own inflation-adjusted $12,060,000 exemption ($24,120,000 total in 2022). Similarly, if in 2022 the first spouse to die leaves $1,000,000 to his or her children, the surviving spouse will have an aggregate exemption of $23,120,000 (use of the remaining $11,060,000 DSUEA in addition to his or her own inflation-adjusted $12,060,000 exemption).
In many cases, however, we will advise our clients to continue to use an irrevocable Residual Trust as part of their estate plans for both tax and non-tax reasons.
Tax reasons include the following: (i) The DSUEA is not indexed for inflation; (ii) eliminating estate tax on any appreciation of Residual Trust assets at the surviving spouse’s death, regardless of the value of the surviving spouse’s assets; (iii) allowing for an allocation of the deceased spouse’s GST exemption to the Residual Trust; (iv) the surviving spouse could remarry and be limited to using the unused exemption of his or her later predeceased spouse if any (a DSUEA thus may inhibit remarriage); and (v) an estate tax return must be filed timely to qualify for portability.
Non-tax reasons include the following: (i) Limiting (or eliminating) the ability of the surviving spouse to direct the disposition of the deceased spouse’s former assets at the surviving spouse’s death; (ii) restricting the surviving spouse’s right to use principal (perhaps only for health, support, and maintenance); (iii) providing creditor protection (creditors generally cannot reach the assets in an irrevocable trust established by another person); and (iv) providing professional management if desired.
Residual Trust disadvantages include the following: (i) Annual costs for the preparation of income tax returns for the Residual Trust; (ii) the possible loss of a further stepped-up basis on the surviving spouse’s death; (iii) lack of surviving spouse ability to change the estate plan to adapt to changed circumstances, unless, as is often the case, the surviving spouse has a limited power to change the Residual Trust distribution provisions; (iv) lack of ability to offset capital gains and losses realized by the surviving spouse and the Residual Trust4; (v) Residual Trust assets generally cannot be used to implement further estate planning techniques; and (vi) the surviving spouse cannot use the $250,000 exclusion from capital gain upon the sale of a residence held in the Residual Trust.
E. Four Planning Tips:
(i) If the reasons for establishing a Residual Trust are not significant, but you nevertheless want to provide for the possible establishment of a Residual Trust in case your spouse later decides that it is advisable to do so, your estate plan can provide for distribution of your estate to your spouse, but include a provision that would allow your surviving spouse to “disclaim” all or a portion of his or her inheritance and arrange for the disclaimed assets to be allocated to a Residual Trust (“Disclaimer Trust”). The surviving spouse could make his or her decision to disclaim during the nine-month period following the first spouse’s death. The only difference between a Disclaimer Trust and a Residual Trust established by the first spouse is that the surviving spouse could not have a power to provide for distribution of the assets of a Disclaimer Trust in a manner different from the first spouse’s distribution plan.
(ii) A qualified Marital Trust (“QTIP Trust”) enables a deceased spouse to take advantage of the marital deduction yet still maintain control over the distribution of the trust assets upon the death of the surviving spouse, preserve the deceased spouse’s unused GST exemption through a “reverse QTIP election,” and provide a greater degree of creditor protection than would be afforded by an outright bequest to a surviving spouse. Using a Marital Trust to accomplish these objectives (rather than a Residual Trust) will allow the Marital Trust assets to receive a step-up in basis upon the death of the surviving spouse and, in some cases, may postpone payment of state level estate taxes until the death of the surviving spouse. In addition, the surviving spouse may wish to elect portability and subsequently use the deceased spouse’s remaining estate tax exemption (DSUEA) to make lifetime gifts tax-free.
(iii) If a surviving spouse benefits from an existing Residual (“bypass”) Trust, and the total of the surviving spouse’s assets and the Residual Trust assets is likely to be less than the surviving spouse’s estate tax exemption, it might be advantageous to petition the Probate Court for authority to terminate the Residual Trust in favor of the surviving spouse. If the Residual Trust was created solely for tax planning, and that planning is no longer needed, the Court is likely to grant this authority, especially if the surviving spouse has the ability to change the ultimate disposition of the Residual Trust assets by exercising a power of appointment. On the other hand, if there is a blended family and the ultimate beneficiaries of the Residual Trust are different from the surviving spouse’s beneficiaries (e.g., children from a prior marriage), the Court may not grant the authority to terminate (especially if the step-children file objections to the petition). Alternatively, California has enacted a “decanting” statue, which allows a trustee to transfer assets from one irrevocable trust to another, subject to certain conditions. Thus, it may be possible to transfer the Residual Trust assets to the surviving spouse or to a “grantor” trust that will allow for a “stepped-up” basis at the surviving spouse’s death. Again, there are other reasons to retain a Residual Trust, including creditor protection and the use of the GST tax exemption.
(iv) To protect against a retroactive change reducing the lifetime transfer tax exemption currently set at $12,060,000, consider incorporating one or more of the following “hedging” techniques in making 2022 gifts to use that full $12,060,000 exemption amount:
(a) Allow for disclaimers by beneficiaries and Trustees to “undo” a gift and allow for return of the assets and restoration of the exemption;
(b) Establish a trust for your spouse that will qualify as a marital deduction (“QTIP”) trust if you elect to so qualify the trust on a timely-filed gift tax return, which need not be filed until October 17, 2023. Failure to make the election will result in a taxable gift that uses your lifetime exemption; and
(c) Make a “formula” gift to a trust such as “that fractional share of assets, the numerator of which is my lifetime exemption amount as finally determined for federal gift tax purposes, and the denominator of which is the value of the assets contributed to the trust.”
3. Income Taxes. The following is a brief summary of some of the recent changes to federal income tax provisions relating to individual taxpayers. (California has several legislative proposals pending that will increase income taxes significantly, as well as a first-in-the-nation wealth tax.)
A. The highest tax rate (37%, reduced in 2018 from 39.6%) is imposed on 2022 incomes in excess of $647,850 (was $628,300) (joint return) and $539,900 (was $523,600) (single). These brackets will continue to be adjusted for inflation annually.
B. The 2022 alternative minimum tax (“AMT”) exemption amounts are increased to $118,100 (was $114,600) (joint return) and $75,900 (was $73,600) (single), and phase out thresholds are increased to $1,079,800 (joint return) and $539,900 (other than for estates and trusts, which is $88,300).
C. In 2022, the standard deduction for a single individual is $12,950 (was $12,550) and the standard deduction for joint filers is $25,900 (was $25,100). An additional $1,400 deduction is allowed for each blind and over age 65 taxpayer.
D. The 2018 Tax Act repealed the individual mandate to buy health insurance, effective January 1, 2019, and changed the income tax rules for alimony: For divorce or separation agreements executed after December 31, 2018, no deduction is allowed for alimony payments and no taxable income is recognized when alimony is received. Agreements effective before 2019 are not affected. This change in the law can be overcome in appropriate cases via the use of an irrevocable trust for the benefit of the recipient spouse.
E. The 2018 Tax Act allowed investors to defer capital gains recognized before 2027 by investing in a designated “Qualified Opportunity Zone” (a low-income community). The sale proceeds must be invested in a “Qualified Opportunity Fund” within 180 days from the sale (or date of filing if the gain is reported on a Schedule K-1) in the amount of the gain to be deferred. The deferred gain is taxed upon the later of (a) the sale (or certain other transfers) of the investment or (b) December 31, 2026. But if the Qualified Opportunity Zone investment is held for 10 years, no further gain is recognized upon sale (or certain other transfers) of the investment. The IRS issued final regulations about these investments on December 19, 2019.
F. Since tax years beginning in 2018, partnerships have been audited by the IRS under an entirely new regime. Under the new regime, tax adjustments resulting from partnership audits will generally be assessed at the partnership level. This enables the IRS to collect tax due on partnership adjustments at the entity level, thereby effectively imposing an entity-level tax on partnerships. Although it may be possible for a partnership to “push-out” this tax obligation to its partners, this election will result in a higher rate of underpayment interest. The new regime applies to all partnerships regardless of size or number of partners, unless the partnership is eligible to elect out and does so in a timely manner. Typically, partnerships eligible to opt out must have 100 or fewer partners and all partners must be individuals, C corporations, foreign entities that would be treated as a C corporation if domestic, S corporations (although each shareholder is counted as a separate partner for the 100 or fewer requirement), or an estate of a deceased partner. Importantly, partnerships with partners that include other partnerships, single-member LLCs, grantor trusts (including revocable trusts), or nominee partners will prevent a partnership from opting out of the new rules regardless of the number of partners. This new IRS audit regime has created a number of unanswered questions and significant concern over the manner in which partnerships will be audited and potentially subjected to imputed underpayment obligations. Given these concerns, it is very important that all partnership/LLC members discuss with their professional income tax advisors changes to the entity’s governing documents that will probably be necessary. The most significant of these changes will be the determination and identification of a designated “partnership representative” (“PR”). Unlike the “Tax Matters Partner” under the formally applicable unified audit procedures, the PR will have increased decision making power and authority that will have significant impact on all owners and the entity in the event of an examination. In addition to the PR designation, there will be several matters the owners will want to consider with respect to various elections, allocations, and the payment of IRS assessments.
G. The Further Consolidated Appropriations Act, signed by President Trump on December 20, 2019, included the Setting Every Community Up for Retirement Enhancement Act of 2019 (“SECURE Act”). The SECURE Act was effective on January 1, 2020, and includes the following provisions among many others relating to retirement plans:
(i) Required beginning date for minimum distributions is now April 1 of the calendar year following the year in which the participant attains age 72 rather than 70½ and contributions to traditional IRAs can continue until death, limited by taxable compensation (maximum contribution in 2022 remains $6,000 or $7,000 for taxpayers over age 50); and
(ii) All distributions after the participant’s death must be made by the end of the tenth calendar year following the year of the participant’s death, subject to exceptions for surviving spouses, minor children of the participant (during minority), individuals not more than 10 years younger than the participant, and “disabled” beneficiaries. These “eligible designated beneficiaries” may continue to take distributions over their lives or life expectancies. After an eligible designated beneficiary’s death, the remaining account balance must be distributed within the next 10 years. In order to take this new (“anti-stretch”) rule into account, everyone who has planned for post-death distributions lasting longer than 10 years must review the beneficiary designations of his or her plan, including the provisions of trusts designated as beneficiaries, and perhaps consider converting a traditional IRA to a Roth IRA or designating a charitable remainder trust or establishing a charitable gift annuity as beneficiary as discussed in paragraph 12.
H. In July 2018, the IRS announced a campaign focused on cryptocurrency transactions. Cryptocurrency is treated as property rather than cash. Accordingly, taxpayers with unreported virtual currency transactions should consider complying with the tax reporting requirements relating thereto. The “Build Back Better” proposal includes many new reporting requirements. Although no special voluntary disclosure program exists, in some cases the IRS will discount the penalties for taxpayers who voluntarily amend their prior years’ tax returns.
I. In January 2018, the IRS issued a notice to alert delinquent taxpayers who owe at least $50,000 ($55,000 in 2022) that it will be implementing its right to advise the State Department to revoke their passports. The IRS chief counsel has advised that, to date, this program has been successful.
4. California Property Taxes.
A. Under prior California law, which was changed after February 15, 2021, a parent could transfer the following types of California real property to a child or a trust for the child’s benefit without triggering a reassessment (“Parent-Child Exclusion”):
(i) A principal residence of unlimited fair market value; and
(ii) The first $1,000,000 (or $2,000,000 for married couples) of assessed (not fair market) value of any other type of real property.
B. Proposition 19 was passed as a ballot initiative in 2020, which
(i) limits the Parent-Child Exclusion for a transfer of a principal residence as follows:
(a) The child must live in the residence; and
(b) If the current fair market value of the residence exceeds the current assessed value of the residence by more than $1,000,000, the value exceeding $1,000,000 will be reassessed; and
(ii) eliminates the $1,000,000 (assessed value) Parent-Child Exclusion, resulting in a reassessment of any property other than a principal residence transferred to a child.
5. Revocable Trust. The revocable trust is a valuable estate planning technique for both single and married clients, used primarily to avoid the inconvenience and extra costs of a probate administration of an estate upon death (multiple probate administrations would be required if you own property in other states). The same estate tax savings techniques available by Will can be employed via a revocable trust. Many of the post-death income tax advantages previously available to probate estates but not to revocable trusts have been eliminated, thus making the revocable trust even more attractive for wealthier clients. We usually suggest that our California clients use revocable trusts rather than Wills as their primary estate planning vehicles.
An Israeli income tax may apply to a revocable trust (including those created prior to 2022) of which at least one beneficiary is an Israeli resident, even if there are no assets in Israel, no trustee in Israel, and the trustor is not an Israeli resident.
6. Annual Gift Program. A lifetime gift-giving program could reduce overall transfer tax costs considerably. By receiving lifetime gifts, donees will benefit from all future appreciation of, and income generated by, the transferred property free of transfer taxes. This year, every individual may transfer cash or other property worth $16,000 (or $32,000 for married couples) to each of as many donees as the donor selects without incurring any gift or later estate tax. An inflation adjustment applies when that adjustment would increase the annual exclusion amount by $1,000 (e.g., to $16,000 in 2022). Donors may make these gifts (known as “annual exclusion” gifts) outright or via custodianships or trusts, although careful planning is needed if trusts are to be used. For example, it is very important to ensure that any trust for a grandchild contains special provisions so that gifts made to that trust are exempt from the GST tax (discussed in paragraph 8). In addition, no gift taxes are imposed if you pay a donee’s tuition or medical expenses (payments must be made directly to the school or healthcare provider), and you may prepay tuition under certain circumstances.
Even if a gift is not “tax-free” as described above, if your aggregate gifts do not exceed the $12,060,000 lifetime gift tax exemption amount (or $24,120,000 for married couples), no gift tax will be payable at the time of the gift. Taxable gifts in excess of the $12,060,000 lifetime exemption will accelerate transfer tax payments, but an overall tax savings may result because your gift tax dollars generally will not be subject to estate taxes at death. Use of the increased exemptions before they expire or perhaps are modified by the Biden administration should be considered because of the “use it or lose it” rule discussed in footnote 2. Certain valuation advantages (such as “minority” discounts) that might be unavailable at death often are possible under current law in connection with lifetime gifts (e.g., see paragraph 16). Finally, the relatively low interest rates still in effect make this a very good time to loan funds to younger generations and may make certain types of gifts via trust particularly attractive as described in our “LOW INTEREST RATE GIFT PLANNING” memorandum below.
7. Life Insurance. Life insurance proceeds are generally exempt from income tax. In addition, all estate tax on life insurance proceeds may be avoided on the death of the insured through proper planning: Insurance proceeds can be available free of estate tax to the surviving spouse, but by designating other family members or a trust for their benefit as owners and beneficiaries, estate taxes can be avoided in both spouses’ estates. “Joint life” (or “survivorship” or “second to die”) policies make life insurance planning affordable for many more people. You should consider the ownership and beneficiary designations for any newly acquired life insurance carefully before the policy is purchased. You also should review the ownership and beneficiary designations of your existing policies; your revocable living trust or Will does not generally control distribution of life insurance proceeds. “Split-dollar” life insurance plans are subject to stringent rules; we suggest that you review with an insurance professional or with us any “split-dollar” life insurance programs in which you currently participate or in which you contemplate participating. Some life insurance policies now include a long-term care insurance option. Finally, recent economic activity may have caused your life insurance policies to experience financial problems; you may wish to contact your insurance professional to discuss the current status of your policies.
8. GST Tax. The GST tax generally imposes an additional transfer tax (at the 40% estate tax rate) on property transferred to grandchildren and other younger beneficiaries by lifetime gift or at death, and whether outright or via trust. Certain techniques are available to avoid or substantially reduce this GST tax. One technique involves making “tax-free” gifts as described in paragraph 6 via an “annual exclusion” gift program to grandchildren (either outright or via trust) and by paying a grandchild’s tuition and medical expenses (remember, direct payments to the school or healthcare provider are required). Another technique involves use of your lifetime GST exemption to establish a “dynasty” trust (which can invest in life insurance policies or other property) to enable a substantial amount of property to pass to grandchildren, great-grandchildren, and later generations free of any GST tax. Certain recent legislative proposals would reduce severely the advantages of a “dynasty” trust by reducing the maximum length of the GST exemption. The GST exemption for 2022 is the same as the unified $12,060,000 gift and estate tax exemptions. Whereas use of the gift and estate tax “exemptions” is automatic, use of the GST exemption is elective. In view of the voluntary GST exemption allocation rules, we generally recommend that clients who make gifts to trusts from which a grandchild or other younger beneficiary may receive distributions file gift tax returns (even if not required) in order to specifically elect whether to allocate or not allocate GST exemption to those trusts.
9. Marital Deduction; Noncitizen Spouse. The vast majority of married couples combine the estate tax “exemption” granted to each person with the unlimited marital deduction to ensure that no estate taxes are payable until the death of the surviving spouse. The unlimited marital deduction generally is available for gifts and bequests to spouses; those gifts and bequests can be outright transfers or can be made via trusts (although not all types of trusts will qualify for the marital deduction). Severe restrictions, however, are imposed on the ability to defer estate taxes if the surviving spouse is not a U.S. citizen (the surviving spouse’s residence is not a factor). Under these rules, property passing to a noncitizen surviving spouse must be held in a special type of trust (a “qualified domestic trust”) in order to qualify for the marital deduction. In addition, although gift taxes on gifts to noncitizen spouses generally cannot be deferred via the marital deduction, in 2022 you may make “annual exclusion” gifts (discussed in paragraph 6) of a maximum of $164,000 (rather than $16,000) to your noncitizen spouse (subject to annual inflation adjustments). As discussed in paragraph 2-D, portability is not available if either spouse is a nonresident alien (“NRA”) (a noncitizen who is not a U.S. resident). You should review your estate plan now if either spouse is not a U.S. citizen.
10. Estate Planning for Nonresident Aliens (“NRA”). The estate of an NRA has only a $60,000 (not $12,060,000) estate tax exemption available (and no gift tax exemption). U.S. donees of gifts from NRAs or foreign estates in excess of $100,000 [or $17,339 in 2022 (inflation adjusted) from a foreign corporation or partnership] must report these gifts to the IRS on Form 3520. Several interesting planning opportunities may exist for an NRA. An NRA may avoid transfer taxes completely by structuring his or her holdings so that no U.S. “situs” assets are owned directly (for example, U.S. “situs” assets may be held by a wholly-owned foreign corporation, although U.S. real estate presents special income tax issues). If your spouse is not a U.S. citizen, you may wish to defer estate taxes by use of a “qualified domestic trust” (discussed in paragraph 9 above). Lifetime gifts by an NRA of U.S. “situs” intangible personal property (such as securities or partnership interests) are not subject to U.S. gift taxes, even though these items would be subject to U.S. estate taxes if owned by the NRA at death. An NRA also may wish to establish a foreign revocable trust to hold property for U.S. resident family members to provide them with tax-free income and arrange for the trust property to pass to them free of transfer taxes and with a “stepped-up” basis (although certain recent legislative proposals would eliminate the “stepped-up” basis advantage).
A U.S. taxpayer who expatriates (“covered expatriate”) can be subject to severe tax penalties unless that taxpayer has a net worth of less than $2,000,000 and average annual income of not more than $178,000 (subject to annual inflation adjustments). The tax penalties can be deferred on an asset-by-asset basis if an election is made (interest and security are required). In addition, a 40% transfer tax is imposed on the receipt by U.S. taxpayers of any amounts in excess of $16,000 (adjusted for inflation) from a “covered expatriate.” The IRS issued Proposed Regulations in September 2015 concerning the donee’s duty to report receipts from a “covered expatriate” on new IRS Form 708 (yet to be released).
11. Community Property v. Joint Tenancy. For income tax purposes, both “halves” of appreciated community property receive a “step-up” in basis upon the death of either spouse. Because only one-half of the basis of property held in joint tenancy receives a basis “step-up” at the death of the first spouse, we generally recommend that legal title to appreciated assets owned jointly by spouses and not held in a revocable living trust be held as “community property” rather than as “joint tenants.” California recognizes “community property with right of survivorship” as a form of legal title for real estate.
12. Charitable Tax Planning. There are several techniques available to transfer significant wealth to intended beneficiaries in a tax-favored manner and at the same time benefit charity. This is particularly true in connection with a sale of highly appreciated assets; a charitable remainder trust can be used to advantage in these circumstances. You also may be able to arrange to receive a lifetime annuity in exchange for cash or appreciated property, or even for agreeing to transfer your residence to a charity at your death (or at the death of the surviving spouse). Additionally, you may be able to transfer property to your descendants without (or with reduced) transfer taxes by establishing a charitable lead trust (these are particularly advantageous in a low interest rate environment as currently exists, as discussed in our “LOW INTEREST RATE GIFT PLANNING” memorandum below). The income tax benefits of donating partial interests in tangible personal property items (such as works of art) are currently restricted. The popular “Charitable IRA Rollover” rules were made permanent in 2015; these rules are discussed in paragraph 14 below. Wealthier taxpayers may be interested in a private foundation or a donor-advised fund established at a public charity, such as a community foundation. The IRS has developed two web pages that may be of interest to these taxpayers: “Life Cycle of a Private Foundation” and “Life Cycle of a Public Charity.”
13. “Buy-Sell” Agreements/Options. A “Buy-Sell” or option agreement (whereby a family member or business associate has the obligation or option to acquire assets at an established price) can be used to advantage in connection with business succession planning to restrict ownership of a business, to establish the value of an asset for estate tax purposes, and to provide a market for the asset to allow owners to plan for liquidity. This estate planning device is subject to restrictions, but some of these restrictions do not apply to agreements made before October 9, 1990. You therefore should be very careful if you wish to modify “Buy-Sell” or option agreements made prior to October 9, 1990. Employer-owned life insurance generally now is subjected to income taxation, although insurance used to fund a Buy-Sell Agreement is exempt from income taxation, provided that certain written notice and consent requirements are met in advance.
14. Employee Benefit Plans and IRAs. Assets in pension and profit-sharing plans, IRAs, and other retirement plans (other than Roth plans) can be subject to severe income taxes at death. You should review your plan benefits to determine whether you can avoid or postpone these taxes and whether your plan benefits are coordinated with your estate plan; your revocable living trust or Will generally does not control disposition of these benefits. Plan proceeds still can be the most advantageous to use for charitable gifts at death, including transfers to charitable remainder trusts and to establish charitable gift annuities. This is especially true after the recent SECURE Act discussed in paragraph 3-G-(ii). The “Charitable IRA Rollover” provisions were made permanent in 2015, so taxpayers who attain age 70½ (unchanged by the SECURE Act) can direct a maximum of $100,000 (reduced by post-age 70½ IRA contributions) to charity from an IRA (only); the payment will not be included in the taxpayer’s income for the year, but it nevertheless will count against the taxpayer’s “minimum required distribution” for the year. No charitable contribution deduction will be allowed, but most taxpayers nevertheless would benefit by using this technique as opposed to withdrawing funds from an IRA (taxable) and contributing those funds to charity (deductible, but subject to certain limitations).
15. Subchapter “S” Corporations. The use of Subchapter “S” corporations has become somewhat less popular because of the increased use of limited liability companies (“LLCs”). Care must be taken, however, with respect to existing Subchapter “S” corporations. For example, upon the death of a Subchapter “S” corporation shareholder, Subchapter “S” corporation status can be lost unless the decedent’s shares pass to a qualified shareholder in a timely manner. All Subchapter “S” corporation shareholders therefore should ensure that their estate plans allow for the continuation of Subchapter “S” corporation status and consider implementing a “Shareholder Agreement” to restrict stock ownership and perhaps require minimum cash distributions in order to fund required estimated tax payments.
16. Family Limited Partnerships and Limited Liability Companies. A “family limited partnership” (“FLP”) or “family limited liability company” (“FLLC”) can be an excellent estate planning vehicle for clients who own valuable assets. A FLP or FLLC can be advantageous if a family member encounters creditor problems in the future. Gifts of FLP or FLLC membership interests to your beneficiaries or to trusts for their benefit can qualify for the gift tax “annual exclusion” (discussed in paragraph 6) if properly drafted, and the value of those gifts can reflect the “discounts” available for minority and nonmarketable interests. “Discounted” values also can be used in connection with sales to desired limited partners or LLC members, including family members or trusts for their benefit. Certain recent legislative proposals would eliminate “discounts” for non-business assets. Some IRS challenges to these entities have been successful, however, so all administrative and operational details must be respected; some court decisions have focused on the actual organizational and operational aspects of the family entities. The tax benefits anticipated at the time of the formation of the entity should be available at the donor’s death if the entity is organized for a significant non-tax business purpose and operated strictly in accordance with the provisions of the governing instrument and applicable state law, the donor has retained enough assets outside the entity to satisfy the donor’s personal financial needs, and the donor is not a general partner or LLC manager.
17. Durable Powers. It has become more important to plan for the risk of lifetime incapacity. A Durable Power of Attorney can provide for lifetime asset management, especially if your estate plan does not include a revocable living trust. An Advance Healthcare Directive permits you to designate someone to make healthcare decisions on your behalf if you become unable to do so, and also can be used to make known your desires that artificial life-prolonging measures be or not be employed on your behalf. Appropriate healthcare documents for your children (both minors and adults) also should be completed. A Durable Power of Attorney for Healthcare signed prior to 1992 in California probably is ineffective today. The California Secretary of State has established an Advance Healthcare Directive Registry and will issue an identification card to each registered person and respond to inquiries by healthcare providers. A registration form can be obtained here. In addition, you should consider executing an appropriate authorization for use and disclosure of health information that otherwise would be protected and thus unavailable under the federal Health Insurance Portability and Accountability Act (“HIPAA”).
18. Estate Planning Review. It is always good to review estate planning documents to see if they still accomplish your goals.
Changes in circumstances, such as a marriage or divorce, a change in financial situation or liquidity, retirement, and births and deaths might necessitate revisions to an estate plan. Life insurance needs also may have changed.
Old estate plans that make gifts based on formulas tied to an exemption amount that has changed, such as gifts to grandchildren, children from a prior marriage, charity, or others might require revision because the amount of those gifts may be drastically different under current law from what was envisioned.
Beneficiary designations of retirement accounts and life insurance policies should be reviewed to determine whether they need to be changed [see paragraph 3-G-(ii)].
Legal title to trust assets should be in the name of the trust. Also, for married couples, how title is held (i.e., joint tenancy or community property) may affect the basis adjustment on the death of the first spouse as discussed in paragraph 11.
Gifts to certain irrevocable trusts, particularly life insurance trusts, might trigger withdrawal rights for its beneficiaries. Written notice of those rights must be given (“Crummey” notices). Failure to send these notices may result in adverse tax consequences.
Designations of individuals named as fiduciaries (e.g., guardians for minor children, trustees, executors, conservators, financial agents under durable powers of attorney, and health care agents) should be reviewed to ensure that they still are appropriate.
19. Same-Sex Marriages; Registered Domestic Partnerships. The U.S. Supreme Court has held that same-sex couples have a Constitutional right to marry. This decision may significantly impact an estate plan and may have important tax (as well as marital dissolution and property settlement) consequences. Below is a list of some of those consequences, many of which may be retroactive.
- The availability of the marital deduction for both gift and estate taxes, including the ability to transmute separate property of one spouse to community property (or vice versa) without negative gift tax consequences.
- The treatment of retirement benefits and the availability of the spousal rollover IRA.
- The opportunity to file one joint income tax return or two separate returns as married filing separately.
- Both spouses may use the gift, estate, and GST tax exemptions, tax advantages of “split gifts” for gift tax purposes, and the ability to use portability.
- Increased healthcare access and rights.
- Increased opportunities for international estate planning and citizenship.
20. Digital Assets. This is an often overlooked category of assets that you should consider when creating an estate plan. Many people have multiple digital accounts, and those accounts may be inaccessible when the owner becomes incapacitated or dies. Automatic payments from bank accounts would continue until the bank is notified. California adopted the Revised Fiduciary Access to Digital Assets Act, effective January 1, 2017, which will determine who, if anyone, can access your digital assets. You may use an “online tool” (such as Google’s “Inactive Account Manager”) or provide for your digital assets in your estate planning documents, or the “terms of service” agreement will govern the disposition of your digital assets.
21. Deposit Insurance. The FDIC bank deposit insurance limit is $250,000 per account. Generally, all retirement accounts of a single “participant” at a particular bank are insured up to $250,000. All accounts held by a revocable trust are insured on a “per settlor per beneficiary” basis. For example, a single revocable trust established by a married couple that provides that, on the death of the first spouse, the assets will remain in the trust for the benefit of the surviving spouse for life, and that on the death of the surviving spouse, the assets will be divided into equal shares for their three children, will be insured while both spouses are living for $1,500,000 at each bank in which the trust maintains accounts (husband is treated as having three $250,000 beneficiaries, and wife is treated as having three $250,000 beneficiaries). This rule will apply regardless of the relationship between the trust creators and the beneficiaries; previous law provided for this protection only to certain close family members. For more information about FDIC insurance for revocable trusts, see the FDIC website.
22. Foreign Asset Reporting. The Treasury Department is actively pursuing taxpayers who fail to report their foreign assets, including foreign bank and securities accounts and foreign fund accounts maintained outside the U.S. on IRS Form 8938 as required by the Foreign Account Tax Compliance Act (“FATCA”). Filing Form 8938 does not relieve U.S. taxpayers (including nonresident U.S. citizens and dual citizenship individuals) from the separate obligation to file a Report of Foreign and Financial Accounts (“FBAR”) (FinCEN Report 114, replacing Form TD F 90-22.1) that must be received by the Treasury Department by April 15 each year (subject to a six-month extension) to report an interest in, or a signature authority over, any financial account in a foreign country if the aggregate value of those accounts exceeds $10,000 at any time during the calendar year. The due date for the Report has been extended to April 15, 2023, for taxpayers who have signatory authority over but no financial interest in an account. Because FBAR regulations do not define a foreign account holding virtual currency as a type of reportable account, a foreign account holding virtual currency is not reportable on the FBAR unless it holds reportable assets in addition to virtual currency. The Treasury Department intends to amend the FBAR regulations to include virtual currency as a type of reportable account. The FBAR must be filed electronically. These two forms must be filed even if the accounts or assets earned no income. IRS Form 8938 must be filed with a U.S. resident’s income tax return if total foreign financial assets aggregate $50,000 at year-end or $75,000 at any time during the year (single or married filing separately) or $100,000 at year-end or $150,000 at any time during the year (joint return). Severe penalties may be imposed for failure to comply with either of these filing requirements. The IRS currently offers its “Streamlined Compliance Procedures,” a program designed for taxpayers whose failures to report their foreign accounts were negligent or not willful. The IRS has been auditing taxpayers in a campaign that focuses on people who withdrew from or were denied entry into the agency’s closed offshore voluntary disclosure program. The IRS has issued a memorandum outlining new voluntary disclosure procedures that will allow taxpayers to escape criminal prosecution (but generally not avoid penalties). FATCA, which became effective on July 1, 2014, requires foreign financial institutions to report the identities of their U.S. depositors to the IRS. The Corporate Transparency Act became law on January 1, 2021, requiring certain business entities to report their beneficial owners to FinCEN.
23. Blank Rome LLP Partner Honored Again. We are proud to advise you that Blank Rome LLP partner William Finestone was again named as a “Southern California Super Lawyer” (Estate Planning & Probate) by Los Angeles Magazine (honoring the top 5% of lawyers in their respective fields as determined by surveys of other lawyers). William also is included as a “Best Lawyer in America” (Non-Profit/Charities Law and Trusts and Estates) in the 2022 edition of that publication, among “The 2022 Los Angeles’ Best Lawyers” as published in The Wall Street Journal, a “Top Rated Lawyer” by The American Lawyer, a “Top Attorney” by The American Registry, and a “Top Author” by JD Supra.
24. Regulatory Notices. We are providing this newsletter and the “LOW INTEREST RATE GIFT PLANNING” memorandum as a commentary on current legal issues and as a service to our clients and friends; neither should be considered legal advice, which depends on the unique facts of each situation. Receipt of this newsletter and the memorandum does not establish an attorney-client relationship. Inflation is now measured using the “Chained Consumer Price Index for All Urban Consumers” (“C-CPI-U”), which will result in lower/slower inflation adjustments. Base year is 2016.  Taxpayers who do not take full advantage of the increased exemption amounts before they expire will lose the ability to use the unused portion of the 2018 increases (“use it or lose it”).  The GST exemption is not portable. An allocation of a decedent’s GST tax exemption to the Residual Trust at death can reduce GST taxes if assets are left to benefit grandchildren, either directly or in a trust benefitting both children and grandchildren.  These disadvantages can be eliminated if the surviving spouse has a right to withdraw all Residual Trust income rather than including a provision requiring the Trustee to distribute all income to the surviving spouse.
Memorandum: Low Interest Rate Gift Planning
While you still have all of 2022 to take advantage of annual exclusion gifts ($16,000 per donee) and the increased lifetime gift tax exemption (now $12,060,000 per taxpayer), we recommend that you not wait too long to take advantage of the current low interest rate gift opportunities for a number of reasons, including the advantage that once a gift is made, any future appreciation of the transferred property and any future income generated thereby will escape transfer taxes.
In addition, future legislation could limit your gift planning opportunities. Proposed changes that have been discussed in the past and that are likely to be discussed again include (i) eliminating “discounts” for closely-held business and real estate interests; (ii) prohibiting short-term (e.g., two-year) or eliminating the benefits of all Grantor Retained Annuity Trusts (“GRATs”) (discussed below); and (iii) limiting or eliminating the benefits of “defective” grantor trusts (discussed below) and long-term “dynasty” trusts. None of these changes has been enacted yet but for those in a position to do so, we strongly recommend that you take advantage of your gift tax planning opportunities sooner rather than later, after considering the impact of your gifts on your donees.
Low Interest Rates
On or about the 20th of each month, the Internal Revenue Service (“IRS”) issues its Applicable Federal Rates (“AFRs”) that are applicable for many federal income tax purposes for the following month. These minimum interest rates are a key component in many estate planning strategies, and lower rates provide significant opportunities to shift wealth to junior generations. The AFRs for January 2022 are very low: The rate for a loan of less than three years (“short-term”) is only 0.44%; the rate for a loan of between three and ten years (“mid-term”) is only 1.30%; and the rate for a loan of ten or more years (“long-term”) is 1.82%.
The rates could rise in 2022. You, therefore, may wish to take advantage of one or more of the following opportunities now:
(i) Establish a GRAT;
(ii) Make “intra-family” loans to your children or grandchildren, or to trusts for their benefit;
(iii) “Refinance” existing intra-family loans that bear higher interest rates; and
(iv) If you have philanthropic goals, consider the following:
(A) Estate tax savings. A charitable lead annuity trust (“CLAT”) is a statutorily sanctioned trust that lasts for a specified number of years and provides for specified amounts to be distributed each year to charity during the CLAT term. Any growth in the CLAT assets in excess of the IRS specified rate (the “7520 Rate,” which is 1.6% for January) passes to the non-charitable remainder beneficiaries (e.g., your children) at termination of the CLAT, free of gift or estate tax; and
(B) Income tax savings: A gift to charity of a “remainder interest” in a personal residence or farm produces better results with lower interest rates. Because your retained use of the realty is equivalent to a retained income stream, the lower the interest rate, the less your retained interest is deemed to be worth (and correspondingly, the more your charitable gift is worth), so your charitable contribution deduction is greater. For example, a donor age 70 who contributes the “remainder interest” in a $1,000,000 residence not subject to a mortgage to charity in January (1.6% 7520 Rate) will be entitled to an income tax deduction of approximately $803,000 (rather than approximately $480,000 at a 6% 7520 Rate).
Transfers to GRATs
By way of brief background, a GRAT is another statutorily sanctioned type of trust (similar to a CLAT) whereby you (the “Grantor”) transfer property to the trust but Retain the right to receive specified payments (Annuity) from the Trust for a specified number of years, after which the GRAT property is distributed to your donees. The specified payments are often structured so that, after accounting for the 7520 Rate of return on the property transferred into the GRAT, the present value of the payments you are to receive will equal the value of the property you transferred into the GRAT. When the annuity payments are structured in this manner, the GRAT is often said to be “zeroed-out” because your donees’ remainder interest has no value for gift tax purposes; thus, no gift tax is payable and no gift tax exemption is used in connection with your funding of the GRAT. To the extent that the investment return on the GRAT property exceeds the 7520 Rate, value will remain in the GRAT after all annuity payments are made, thereby effecting a tax-free gift of the excess return (provided you survive the GRAT term). Accordingly, to the extent that the investment return of a GRAT established in January 2022 exceeds 1.6%, there will be a tax-free transfer of assets to the ultimate beneficiaries of the GRAT (typically your children).
As a result of the historically low interest rates, it’s also a good time to loan money to younger family members or trusts for their benefit. As noted above, the minimum interest rate in January 2022 for a loan of up to three years is 0.44%, and loans between three and ten years carry a minimum interest rate of only 1.30%. To the extent that the loan recipients are able to invest the borrowed funds and generate a return greater than the minimum interest rate, wealth will have been successfully transferred without any gift tax.
For example, if a loan of $1,000,000 were made for 35 months at 0.44%, and if the borrower invests that $1,000,000 in an investment earning 5% after taxes, the excess after 35 months of $107,222 will have been transferred to the borrower free of gift tax.
Finally, if you currently hold an outstanding promissory note that has an interest rate significantly higher than current interest rates, you can refinance that note now to generate additional cash for your donee and reduce your taxable income.
“Defective” Grantor Trusts
Instead of making loans or gifts directly to family members, a more tax-effective option is to make loans or gifts to a “defective” grantor trust for their benefit. A “defective” grantor trust is a type of trust in which all income is taxable to you individually, even though that income inures solely to the benefit of the trust beneficiaries. This in effect permits additional “gifts” to the beneficiaries (in an amount equal to the income taxes) without your being considered to have made any further taxable gifts.
Similarly, it may also be appropriate to sell assets to a “defective” grantor trust in exchange for a promissory note. No taxable gain is recognized by reason of that sale, and no taxable income is recognized by reason of your interest receipts. If the assets that are sold to the trust appreciate at a rate that exceeds the currently low minimum interest rate, wealth will inure to the benefit of the next generation without the imposition of gift tax.
Once you make a gift, you, of course, lose access to that property. You should not give away property if you may need it someday, although you should be able to borrow funds from the gift trusts that you have established. If paying additional income taxes by reason of a “defective” grantor trust later becomes burdensome, you can release the “defective” feature to eliminate the imposition of future income taxes.
The recipient’s income tax basis in property received by gift generally is the donor’s basis; thus gifts of high-basis property are more tax-efficient. If you have created a “defective” grantor trust with low basis assets, you later can exchange cash or higher basis assets tax-free for the low basis assets originally given to that trust so that the assets will receive a “stepped-up” basis at the donor’s death. You may be able to borrow cash for this purpose.
Finally, if the property loses value after the gift, you will have used more exemption by making the gift than would be used at your death. Although the proposed regulations under Internal Revenue Code Section 2704 have been withdrawn, they could be reintroduced under the Biden administration or be the subject of new legislation.  A GRAT and a “defective” grantor trust are “grantor” trusts and new legislation could eliminate “grantor” trust advantages.  Reducing the existing rate may have adverse income tax consequences under certain circumstances.