Planning for Proposed Changes in the Tax Code

March 16, 2012Articles The Legal Intelligencer

In the movie "Groundhog Day," the character played by Bill Murray was forced to relive the same day over and over again. For taxpayers and their advisers, 2012 may very well be a version of "Groundhog Day" as we relive all of the uncertainty of 2009 and 2010, as many of the so-called Bush tax cuts are again scheduled to expire on Dec. 31.

On Feb. 13, President Obama released his Federal Budget Proposals for Fiscal Year 2013 and the Treasury Department simultaneously released its "General Explanations of the Administration's Fiscal Year 2013 Revenue Proposals" (this annual release is often referred to as the "Green Book"). Although the Green Book contains over 130 proposed tax changes for businesses and individuals, the most significant of these changes for individuals involve allowing many of the Bush tax cuts to expire, especially for upper-income and high-net-worth taxpayers.

Most of the Bush tax cuts were originally contained in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). Most of the provisions contained in EGTRRA were scheduled to expire on Dec. 31, 2010. After several years of uncertainty, EGTRRA was effectively extended until Dec. 31, 2012, by the last-minute passage of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (TRUIRJCA), on Dec. 17, 2010.

In the income tax sphere, EGTRRA reduced the two highest individual income tax rates from 36 percent and 39.6 percent to 33 percent and 35 percent, respectively. For 2012, the 33 percent rate applies to taxable income over $217,450 for married taxpayers filing jointly and the 35 percent rate applies to taxable income over $388,350. The administration proposes to replace part of the 33 percent and all of the 35 percent tax rates with the prior top tax rates of 36 percent and 39.6 percent, applicable for taxpayers with taxable income in excess of $250,000 for joint filers ($200,000 for single filers).

In the area of capital gains, current law imposes a maximum tax rate of 15 percent on qualified corporate dividends received by individuals. The administration's proposal reverts to prior law and would tax all dividends as ordinary income, subject to the new tax rates of up to 39.6 percent. Similarly, the current law maximum tax rate of 15 percent on long-term capital gains would revert to the old prior law maximum tax rate of 20 percent. The administration's proposal retains the 0 percent tax rate on capital gains earned by lower-bracket taxpayers whose income is taxed at the 10 or 15 percent ordinary income tax rates. The special tax rate of 25 percent on depreciation recaptured upon the sale of depreciable real estate would also be preserved. The administration also proposes to reinstate the limitation on itemized deductions and the phase-out of the personal exemption for upper income taxpayers.

Under EGTRRA, beginning in 2002, the top tax rate for the federal estate, generation-skipping transfer (GST) and gift taxes was reduced incrementally from 55 percent until it reached 45 percent in 2007. Moreover, the prior $1 million exclusion for estate and GST tax purposes was increased incrementally until it reached $3.5 million in 2009. During this post-EGTRRA period through 2009, the gift-tax exclusion remained at $1 million. However, to satisfy certain budgetary contortions, EGTRRA contained both a temporary elimination of the estate and GST taxes in 2010 and a complete "sunset" in 2011. Under EGTRRA, for 2010, the estate tax was to be replaced with a carry-over basis treatment of bequests, the GST tax was not applicable, and the gift tax remained in effect with the $1 million exclusion and a 35 percent tax rate. Moreover, absent legislation, all of the rate reductions and exclusion increases contained in EGTRRA were scheduled to "sunset" in 2011 with a return to the pre-EGTRRA unified estate, GST and gift-tax exclusion amount of $1 million and a top tax rate of 55 percent.

As stated above, most of the EGTRRA provisions relating to the estate, GST and gift taxes, as extended by the TRUIRJCA, are now scheduled to expire as of Dec. 31. The Obama administration, as reflected in the proposals contained in the Green Book, is prepared to allow most EGTRRA provisions to expire with respect to upper-income and high-net-worth individuals. In addition, the Green Book contains several other proposals that could have a significant impact on tax planning for future years.

The administration proposes to make permanent the estate, GST and gift-tax exclusions and rates as they applied during 2009. Therefore, the top tax rate would be 45 percent and the exclusion amount would be $3.5 million for estate and GST taxes, and $1 million for gift taxes. The portability provision contained in TRUIRJCA, which allows a surviving spouse to utilize the unused estate and gift-tax exclusion of a deceased spouse, would be made permanent. These proposals would be effective for estates of decedent's dying, and for transfers made, after Dec. 31.

The Green Book also contains several estate, GST and gift-tax proposals unrelated to the provisions originally contained in EGTRRA or TRUIRJCA. One proposal would be to provide that on the 90th anniversary of the creation of a trust, the GST exclusion allocated to the trust would terminate. Therefore, any trust distributions after such date could be subject to the GST tax. The 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 trusts that give successive life interests to multiple generations of beneficiaries. In such trusts, no estate tax would normally be incurred as beneficiaries die, because their respective life interests terminate without any inclusion of trust assets in the deceased beneficiary's gross estate. 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 exclusion ($5.1 million in 2012). As explained in the Green Book, at the time of the enactment of the GST tax, the law of most states included the common-law rule against perpetuities (RAP) that generally requires every trust to terminate no later than 21 years after the death of a person who was alive at the time of the creation of the trust. The Green Book explains that because many states have now repealed their RAP statutes, trusts in such states may continue in perpetuity. The administration's proposal essentially provides that after the 90th anniversary of the creation of the trust, subsequent intergenerational transfers would become subject to the GST. This change would be applicable to trusts created or assets contributed to an existing trust on or after the date of enactment.

Another change described in the Green Book would require a minimum term for grantor retained annuity trusts (GRATs). In recent years, GRATs have become a popular technique for transferring wealth among family members while minimizing the gift-tax cost of the transfer. This technique has generally involved the creation of a GRAT with a relatively short term because the technique is ineffective if the grantor of a GRAT dies during the term of the GRAT. The administration's proposal would impose on all GRATs a minimum term of 10 years and a maximum term equal to the life expectancy of the annuitant plus 10 years. The proposal also includes a requirement that the remainder interest in a GRAT have a value greater than zero at the time the interest is created, thereby eliminating the use of so-called "zeroed out" GRATs that incur no gift-tax consequences. This proposal would apply to trusts created after the date of enactment.

Another technique utilized to "freeze" the value of assets for estate tax purposes without incurring any gift-tax consequences involves the sale of assets to certain types of grantor trusts. The grantor of such a trust is treated as the owner of the trust for income tax purposes but as a separate and distinct taxpayer from the trust for estate and gift-tax purposes. The administration's proposal would effectively coordinate the income-tax rules with the estate and gift-tax rules for grantor trusts so that any assets held in a grantor trust would be included in the grantor's estate and any distributions from a grantor trust would constitute a taxable gift by the grantor. These rules would be effective for trust created after the date of enactment or post-enactment transfers to a previously established trust.

Another of the administration's proposals would eliminate the ability of transferors to claim discounts for gift-tax purposes on the value of interests in a family-controlled entity if those interests are transferred to or for the benefit of other family members. These valuation discounts are usually based upon the lack of marketability, liquidity or transferability of the interest and allow transferors to "leverage" the amount of interests they can transfer to family members without incurring gift taxes. The most popular uses of such discounts often involve family limited partnerships and closely-held business interests. Under the administration's proposal, such discounts would generally not be available for transfers made after the date of enactment.

In anticipation of either the automatic expiration of the EGTRRA provisions as of Dec. 31, absent further legislation or the modification of the EGTRRA provisions pursuant to the administration's proposals, upper-income and high-net-worth individuals should give serious consideration to a number of planning opportunities before Dec. 31:

• With the prospect of higher income tax rates, it may be advantageous to accelerate income into 2012. Obviously, such acceleration also serves to accelerate the payment of tax so a "time value of money" calculation may be required. This acceleration would apply to both ordinary income as well as capital gains because the tax rates on both types of income would increase.

• If the administration's estate and gift-tax proposals are enacted (or if the EGTRRA provisions are simply allowed to expire), high-net-worth individuals should make gifts in 2012 to fully utilize their current $5 million gift-tax exclusion ($10 million for married couples). After 2012, the gift-tax exclusion would revert to $1 million and there will be a lost opportunity to transfer significant value (and future appreciation) on a tax-free basis. Moreover, to the extent generation-skipping trusts are intended to be utilized for such gifts, the ability to avoid the GST tax beyond 90 years may be eliminated.

• To the extent significant interfamily gifts are contemplated, consideration should be given to completing such gifts in 2012, not only to take advantage of the increased $5 million gift-tax exclusion but also to take advantage of current law that permits significant valuation discounts on family-controlled entities.

• To the extent a short-term GRAT or a sale to a grantor trust is appropriate as an "estate freeze" technique, these planning techniques will also generally not be available after the date of enactment of the administration's proposals.

It is impossible to predict the future course of tax legislation. So much will obviously depend on the 2012 presidential and congressional elections. However, there is a distinct possibility that upper-income and high-net-worth individuals will be subject to both higher income and wealth transfer taxes after 2012. Therefore, such taxpayers should consider the attractive planning opportunities still available in 2012.

Reprinted with permission from the March 16 issue of The Legal Intelligencer. (c) 2012 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.