Irrevocable Trusts & the Current Federal Estate Tax (IRC 1022), Friend or Foe?

The following is a repost of a blog recently written by Attorney Dale Krause of Krause Financial Services. Attorney Krause is also a fellow member of the National Academy of Elder Law Attorneys (NAELA). The original version can be found here.

An Irrevocable Trust can offer a grantor lifetime control over his or her assets of the trust is established with the following provisions:

• All taxable income shall be disbursed to the grantor;
• The grantor shall have the right to direct how the trust assets are held or reinvested; and
• The grantor shall have a limited power of appointment over the final distributions of the trust; this power shall be in favor of a limited class of beneficiaries, consisting of the grantor’s children and grandchildren; the disbursements do not have to be in equal amounts or shares.

After the trust is established, totally funded, and 60 months passes, the grantor can qualify for Medicaid benefits. None of the trust assets will be included in the grantor’s Medicaid application, in that they are outside of the 60 month look-back period for uncompensated transfers. The grantor will qualify for Medicaid benefits with generally his or her personal property, a prepaid funeral plan, and $2,000.00, or less, of cash assets.

Medicaid eligibility will require that the grantor pay substantially all of his or her monthly income to the nursing home, including that received from Social Security, any pension, and the trust. The only monthly income retained by the grantor is a personal needs allowance, which amount is designed to provide him or her with toiletries and other personal items. Nationally, the personal needs allowance ranges between $30.00 to $101.10.

From an income tax viewpoint, in that the grantor retained all the taxable income, and a limited power of appointment over the final distributions of the trust, the trust is deemed a “grantor trust.” See IRC 671-679. Grantor trusts do not pay any income taxes. Instead, the income flows directly out of the trusts to the grantor, to be placed on their personal income tax returns. For many, the end result is a lower total tax, in that the trust tax rates for individuals are much lower than those for non-grantor trusts.

From an income planning standpoint, in that the grantor retained the right to direct the investment of trust assets, the income taxes can be minimized, or totally eliminated, if the trustee is directed to invest the trust assets in tax-deferred annuities. No income is recognized from a tax-deferred annuity until the trustee either elects to take a withdrawal or annuitize the product.

From a gift tax viewpoint, again, since the grantor retained all taxable income, and a limited power of appointment over the final distributions of the trust, these provisions prevent the funding of the trust from being treated as a “completed gift.” See IRC 2036(a)(10). The end result is that without a taxable gift, no gift tax will be due, nor the requirement that a gift tax return be completed and filed.

Finally, from an estate tax viewpoint, in that the transaction is being treated not as a completed gift, the trust assets will be included in the grantor’s gross estate. The end result is that certain trust assets will receive an automatic step-up in basis. See IRC 1014(a). For example, if a grantor paid $50,000.00 for a house, and made lifetime improvements of $25,000.00, his or her cost basis is $75,000.00. At the time of the grantor’s death, assuming it occurred prior to 2010, if the house was worth $250,000.00, the beneficiaries would receive a tax basis of $250,000.00. Thus, if they later sold it for $250,000.00, or less, they would not owe any capital gains tax. The sale would be tax-free. However, as a result of IRC 1014(a) being repealed on December 31, 2009, the aforementioned tax result will not take place. Instead, if the grantor’s death occurs in 2010, the beneficiaries will receive a tax basis of $75,000.00 – which is likely to result in the payment of capital gains tax when the property is later sold. The present law states that each trust asset will receive a basis equal to the adjusted basis of the property in the hands of the grantor/decedent, or its fair market value on the grantor/decedent’s date of death, whichever is lesser. See IRC 1022.

Congress Does Unthinkable by NOT Addressing Estate Tax

Who wants to ring in the New Year with uncertainty? Well, that’s what Congress did by not getting around to extending the estate tax before December 31, 2009. Many experts believed this would NEVER happen. I discussed this in several past blog entries in September and December of last year.

Flashback to 2001: At that time, a largely Republican coalition in Congress tried to repeal the estate tax completely, but they were unable to get past a filibuster. So, instead, the changes were put into the tax code when then-President George W. Bush signed a bill that was designed to phase out the estate tax so that by January 1, 2010, the estate tax would no longer exist. However, since this was done through the tax code, Congress would have to revisit the changes within ten years, or the estate tax would come back into effect on January 1, 2011, at a higher rate. Generally all experts in the field believed that Congress would act and not allow the estate tax to disappear completely in 2010. But, Congress was so busy debating health care reform this fall that we have entered 2010, and the estate tax is temporarily gone.

So what will happen now? As of right now, if someone dies in 2010, his or her heirs will not owe any taxes on the estate. Sounds pretty good right? Well don’t go “pulling the plug” on Great Uncle Henry just yet. One also has to consider changes to the capital gains tax. Attorney Deirdre Wheatly-Liss wrote a fantastic blog on this topic.  If that same person dies after December 31, 2010, however, with an estate of 1 million dollars or larger, those same heirs will pay a 55% tax. This means that in 2011, a one million dollar estate will be reduced to $450,000, after taxes are paid. Considerinig your life insurance policies are countable in your overall estate, many more middle-class americans will be subject to estate taxes in 2011 if Congress continues to fail to act.

This uncertainty continues when Congress resumes session this year because our representatives may decide to draft a retroactive law reinstating an estate tax that would extend back to January 1, of this year! (Don’t go spending that windfall inheritance quite yet). No one knows howlong it will take Congress to act or what Congress will do. If Congress does act, then the question will be whether a retroactive law would be upheld in court. Unfortunately, it could be a long time, filled with much speculation, before Congress acts and whether that action is deemed constitutional.

While this uncertainty may exist for quite a while, some steps can be taken to protect your family. Please check in with your elder law attorney to learn about potential planning opportunities and to stay up to date on what Congress is doing with regard to the estate tax.

Congress is Down to the Last Hour When it Comes to the Estate Tax Sunset Rules

Tick, tick, tick… The clock is ticking for Congress to act to extend/amend the current estate tax laws. They have about three weeks to prevent the federal estate tax to disappear all together in 2010. Experts agree that it is unlikely for Congress not to act.

The question is, however, will they act in time?

The House approved a bill last week to create an entirely new, permanent, estate tax. According to this bill, estates would have an exclusion for taxes of $3.5 million ($7 million for couples). Under this measure the top tax rate for larger estates would be 45 percent. Another key provision of note is that for tax purposes, assets within an estate’s value is set when the estate holder dies, not when he or she originally acquired the assets. This spares heirs from hefty capital gains taxes on inheritances.

A million isn’t what it used to be

Without new legislation, the sunset provisions of current estate tax rules would erase the tax entirely in 2010. Why would anyone WANT Congress to pass a new Estate Tax then? Hold on to your hats because under the current legislation in 2011 the estate tax will be restored with a 55 percent tax rate and an exclusion of only $1 million. This means that anyone with an estate over $1 million will be subject to a 55 percent estate tax when they die.

Million-dollar estates aren’t as impressive as they once were. As the years pass, many everyday families are millionaires and don’t even know it. When calculating your estate you must include not only the value of what you think of being your assets, but also the value of your home, any vacation properties, and life insurance. Life insurance payouts plus the value of your home can easily put one above this $1 million threshold.

A middle class nightmare?

And while Congress could always take steps in 2010 to change that 2011 scenario, it must act this year to avoid triggering the 2010 estate rules. Losing the estate tax all together in 2010 might seem like a good deal for estate beneficiaries. But an even larger pool of taxpayers might get an unpleasant surprise. That’s because the value of assets in 2010 estates would be set, for tax purposes, at their level when they were originally acquired. In addition to being a bookkeeping nightmare, this provision would trigger capital gains taxes for any estate larger than $1.3 million. It would affect a much higher percentage of middle-class estates than the rules that currently exist.

Have you checked with your Elder Law Attorney?

Very few people have estates large enough to be affected by the newly proposed rules. Those fortunate enough to be among them should stay in touch with their estate planning attorney for further estate-tax developments and planning opportunities.
Check out my previous comments on this topic.

Congress Begins to Work on the Federal Estate Tax

Experts view the current Federal Estate Tax system as a ticking time bomb. Some don’t consider planning for estate taxes because the 2009 threshold is set at $3.5 million. In other words, if you die in 2009 owning less than $3.5 million in total assets, you are not subject to a Federal Estate Tax.
If you die in 2010, as the law currently is written, no one owes estate tax, even if they had one hundred billion dollars (Dr. Evil reference, couldn’t resist). But here’s the rub: if you pass in 2011, the threshold reverts back to $1 million dollars.

Think you don’t have a million dollar estate? Without proper planning your estate can include your primary residence, vacation homes, and even life insurance policies. Still not concerned? The tax imposed can be 40%  to 50% of your total assets. Quite a kick-back to Uncle Sam. Dont’ fret, Congress is working on it!

The rest of this week’s blog is guest-written by Matthew Curtiss, Esq., a former classmate of mine with a practice in Mystic, CT.

With all of the talk of health care, public options, spicy mustard, socialism, and Michelle’s arms; its nice to see some members of Congress address the approaching year-long federal estate tax repeal.  NACSOnline has a nice overview of what proposals have been  put forth to date:

• H.R. 436 – Rep. Earl Pomeroy (ND-at large):
Makes the current exemption of $3.5 million and the rate of 45% permanent. (Estates between $10 million and $23.5 million would be taxed at 50%.).
• H.R. 96 – Rep. Michael Conaway (TX-11): Increases to $1.85 million the maximum reduction amount for alternative valuations of farmland and other business property for estate tax purposes; and restores after 2009 the estate tax deduction for family-owned business interests and increase such deduction to $2 million. Allows annual inflation adjustments to such increased amounts after 2010.
• H.R. 173 – Rep. John Salazar (CO-3): Excludes from an individual’s estate farmland so long as the land continues to be used for farming. To exclude such farmland from the total estate, the individual must have earned 50% of their gross income from farming in at least 3 of the 5 years from the individual’s last tax year and during 5 of the 8 years prior to the individual’s death the land must have been used for farming. If the land is subsequently sold or no longer used for farming a tax will be applied on the heirs.
• H.R. 205 – Rep. Mac Thornberry (TX-13): Repeals the federal estate, gift and generation-skipping transfer taxes.
• H.R. 498 – Rep. Harry Mitchell (AZ-5): Restores the unified credit against gift tax liability; provides for annual increases in the estate tax exclusion amount between 2010 and 2015 and establishes a permanent exclusion amount of $5 million for 2015 and thereafter; provides for an inflation adjustment to the estate tax exclusion amount after 2015; reduces estate tax rate brackets; and allows a surviving spouse to use the unused unified estate tax credit of a deceased spouse.
• H.R. 2023 – Rep. Jim McDermott (WA-7): Sets a $2 million per-person exemption, indexed for inflation, and imposes a 55 percent top rate.
• H.R. 3524 – Rep. Mike Thompson (CA-1): Prevents the value of inherited farmland from being subject to the estate tax if the decedent’s family continues to own it and farm it.

I do like the attempts to keep working farmland totally or partially exempt from tax; as it benefits non-corporate farmers.

For what its worth, with the hearth-care bill taking up so much time, I wouldn’t be surprised to see a one year rollover of the current rates and exemptions.

Thanks to the Wills, Trusts and Estates Prof Blog for the heads up.

For more of Matt’s wisdom, be sure to visit his blog.