Federal Estate Tax and Portability

Posted on August 28, 2012 by Edward Segelken

As a part of the tax changes enacted by Congress in late 2010, the concept of "portability" was introduced into the estate tax law. The implications of this change will be of interest to professionals, business owners and executives.  Careful consideration must be given to the results of estate plans that incorporate this change in the law.

Under portability, when the first spouse dies, his or her estate can elect to transfer any federal estate tax credit (currently equal to the tax on $5,000,000 but scheduled to fall to $1,000,000 under current law) of the deceased spouse to the surviving spouse. Portability permits one spouse to leave all of his or her property to the other spouse without the use of a credit shelter trust and still avoid tax on an amount equal to twice the credit at the second spouse's death. Under prior law, most married persons with estates equal to the amount of the credit equivalent created a trust to hold the portion of their estate equal to the credit in order to avoid losing their credits. This trust, known as a credit shelter trust, does not qualify for the marital deduct and, thus, is not subject to federal estate tax in the second spouse's estate.

To take advantage of portability, it is necessary that the estate of the deceased spouse file a federal estate tax return, Form 706, within nine months of the date of death. Failure to timely file the form will result in the loss of portability.

Relying on portability, however, may not produce the best result.

First, Congress may change the law and eliminate portability. Estate plans relying on portability would then be ineffective.

Second, even if portability remains in the law, there are still advantages to having a credit shelter trust in place.  Consider the following example based on an estate tax credit of $1,000,000 and 55% estate tax (the law after December 31, 2012 unless Congress and the President act).

Without Credit Shelter Trust

Spouse 1 dies with an estate of $1,000,000.  Spouse 2's assets at that date are valued at $1,000,000 as well.  The proper filing is made as described above.  The $1,000,000 passes federal estate tax free to spouse 2.  Between the dates of Spouse 1's death and Spouse 2's death, the $2,000,000 of assets now owned by Spouse 2 appreciates by 50% to $3,000,000.  Spouse 2 would have a total exemption of $2,000,000, leaving $1,000,000 to be taxed at 55%, producing a federal estate tax of $550,000.

With Credit Shelter Trust

Spouse 1 dies with an estate of $1,000,000.  Spouse 2's assets at that date are valued at $1,000,000 as well.  Spouse 1 has a credit shelter trust.  The $1,000,000 passes tax free to that trust.  Between the dates of Spouse 1's death and Spouse 2's death, the $1,000,000 now owned by Spouse 2 appreciates by 50% giving that spouse $1,500,000.  The $1,000,000 in the credit shelter trust also appreciates to $1,500,000.  No portion of the credit shelter trust's assets will be subject to tax at Spouse 2's death because that spouse does not own those assets.  Spouse 2 would have a total exemption of $1,000,000, leaving $500,000 to be taxed at 55%, producing a tax of $275,000.

As you can see, in this example the credit shelter trust produces substantially less tax than the portability planning.  While portability is a safety net for decedent's who have failed to do the proper planning, the use of credit shelter trusts will still be beneficial for many taxpayers.
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Historically Low Interest Rates Create Estate Planning Opportunities

Posted on October 12, 2011 by Mark Snider

For good or for bad, interest rates are currently near all-time lows, including the “applicable federal rate” (“AFR”) which is used to set minimum interest rates for certain gift and estate tax planning techniques. While bankers and financial institution executives routinely consider the implications of such low rates for their institutions, they also should carefully consider the opportunities these low rates create for their estate planning and for that of their customers. Community bank owners and executives, in particular should not overlook these techniques that may help persevere years of wealth creation.

The October 2011 AFR is 0.16% for short-term obligations (up to 3 years), 1.19% for mid-term obligations (more than 3 years, up to 9 years), and 2.95% for long-term obligations (longer than 9 years). Such low interest rates could make this a good time to consider several estate and gift tax planning strategies that are generally more beneficial during periods of low interest rates. Here are some common techniques for bankers to consider: 

Intra-Family Loans

Using an intra-family loan, one person loans money to another with an interest rate that can be as low as the current AFR (set based on the duration of the loan) without triggering gift or estate tax. These loans typically go from an older, wealthier generation to a younger, less wealthy generation. The borrower can use these loans to make investments expected to generate a return higher than the interest rate charged or to pay down higher-rate debt. Any returns the borrower obtains on the loan proceeds in excess of his or her loan payments will be retained by the borrower free of gift or estate tax.

GRATs

Another tax-efficient way to transfer wealth is a Grantor Retained Annuity Trust (“GRAT”). A GRAT allows for the transfer of the anticipated future appreciation of assets to another person without triggering large tax liabilities. With a GRAT, the grantor transfers assets into a trust for a term of years. (Very short-term GRATs have been used in the past, although the IRS is scrutinizing those now that interest rates have fallen sharply.) During the term of the trust, the grantor receives an annuity payment based on the fair market value of the assets placed into the trust. At the end of the trust term, any remaining principal is distributed to the trust beneficiaries, which are generally a younger generation. The taxable gift is equal to the fair market value of the property placed into the trust, less the present value of the annuity payments received by the grantor. The values of the retained annuity payments and remainder interest are based on 120% of the mid-term AFR.

Lower interest rates increase the present value of the retained annuity payments, thereby reducing the value of the taxable gift of the remainder interest. In some circumstances it is possible to structure the GRAT so that the present value of the retained annuity interest equals the value of the property transferred into the GRAT, resulting in no deemed gift to the beneficiaries for tax purposes.

Intentionally Defective Grantor Trusts

A sale to an intentionally defective grantor trust (“IDGT”) may also be attractive when interest rates are low. The transferor sells property to a IDGT in return for an installment note with an interest rate that can be as low as the current AFR. At the end of the trust term, any income and appreciation on the trust assets, minus the note payments, passes to the trust beneficiaries. When the AFR is low, there is a greater chance that the trust assets will generate more income, or increase in value to a greater extent, than is necessary to service the note. 

There are other more complicated techniques that also benefit from low-interest rates, so consultation with knowledgeable professional advisors is appropriate.
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