Tax Deal Trust Fund Loophole Could Save Billions For Rich

Dec. 16 2010 – 9:34 am |

By JANET NOVACK, Forbes Magazine

If the Senate-passed Obama-Republican tax deal clears the House in its current form, rich families will have until Dec. 31 to save billions in Generation Skipping Transfer Tax on money already sitting in trust funds. Noted estate planning lawyer Jonathan Blattmachr, a retired partner of Milbank, Tweed, Hadley & McCloy, says he’s been telling his peers: “Cancel your ski trip or trip to Hawaii. This is a once in a lifetime opportunity.”

The GST tax, in place since 1986, is a second layer of tax applied to gifts and bequests that “skip” a generation—for example, gifts made to grandkids if their parents are still alive. The big, tax saving opportunity comes because the massive tax deal, as passed yesterday by the Senate, not only confirms a 0% GST tax rate for all of 2010, but also creates an additional  loophole that wasn’t available when my colleague Ashlea Ebeling first blogged about a potential end-of-the-year “payday for trust babies”.

The new loophole is this: the money doesn’t (as most planners had believed) have to be distributed outright to the grandkids to qualify for the 0% rate.  Instead, according to the fine print in the tax deal, it can be put in a trust for them, Blattmachr says. That means, he explains, that money can be taken from an existing multigenerational trust, declared subject to the 2010 GST tax, and deposited in a new trust for grandkids’ benefit, with the GST tax now pre-paid at a 0% rate. Transferring money to a new trust answers worries that the grandkids might lose the cash to creditors or in a messy divorce, or blow it on, say, a $2.6 million Bugatti sports car.

Under the tax-cut deal, in 2011 and 2012 the GST tax rate will be 35%, down from the 55% it would have been had the Bush tax cuts simply been allowed to expire. In 2013, if no further legislation is passed, the GST will again be 55%. But that uncertain tax future won’t affect the rich folks who prepay the GST in the next two weeks at no cost, except for lawyers and trust fees.

Money that isn’t yet in a trust and is given to grandkids (either outright or in a trust) before year’s end could also benefit from the 0% rate. But such a transfer, to the extent the giver has used up his or her $1 million lifetime gift tax exemption, would still be subject to a 35% gift tax —and rich people hate paying gift taxes, planners say. (Under the tax deal, each person’s lifetime exemption from gift, estate and GST tax will be “unified” at a hefty $5 million in 2011 and 2012. But that gift tax exemption increase, which itself presents a huge new wealth transfer opportunity for the rich, is not retroactive to 2010.)

Currently, according to Bernard Garbo, editor of Trust Updates, there is somewhere near $1.1 trillion in personal trusts at U.S. banks, trust companies and independent trust companies.  It’s unknown what portion of this trillion dollar hoard represents “non-exempt” multigenerational trusts created over the last quarter century that could benefit from the year-end loophole, but clearly, billions in tax dollars are at stake.  (Non-exempt means the money in the trust is still subject to the GST tax when distributed to grandkids. Some trusts created since the GST tax became law are exempt because the donor either set them up using his or her $1 million GST exemption or paid the GST tax upfront.)

Some of these non-exempt trusts were created at a wealthy person’s death; in other cases the donor is still alive. Technically, this money has already been subjected to the first layer of normal gift or estate tax, although much of it was funneled into the trusts with little or no taxes paid, through such transfer tax minimization devices as Walton GRATs (named after the family which founded Wal-Mart), charitable lead trusts and installment sales to trusts.

Not all non-exempt multigenerational trusts can take advantage of the GST tax loophole. For example, the trustee needs a fair amount of discretion, including the right to “invade principal”.  In addition, only 11 states (Alaska, Arizona, Delaware, Florida, Indiana, Nevada, New Hampshire, New York, North Carolina, South Dakota and Tennessee) allow “decanting”—the movement of money from one trust to another for the benefit of one or more of the trust beneficiaries. But Blattmachr, who helped write New York’s first-in-the-nation decanting law, says that need not be a barrier to trusts in other states, thanks to a law signed by Sarah Palin while she was Alaska’s Governor. That law (also a Blattmachr special) allows out of state trusts to take advantage of Alaska’s decanting law so long as an Alaska co-trustee is named to administer the trust. Not coincidentally, Blattmachr’s brother, Douglas Blattmachr, is founder, president and CEO of Alaska Trust Co. which plans to have all hands on deck to help clients make the most of the GST tax avoidance opportunity through the end of this year.

What if the older generation benefiting from a trust isn’t ready to cede the money to their kids yet? Blattmachr, known (as you have probably deduced by now) for aggressive and creative legal handiwork, has a solution for that too. In some cases it may be possible to decant money into what he dubs a “generation jumping” trust—the trust is exclusively for grandkids, but their parents can be added back in as beneficiaries after five years.

Meanwhile, the entrepreneurial Blattmachr, who also has an estate planning software company,  is planning a webinar next Tuesday to clue in other attorneys on the last minute opportunity. His warning to those who would rather keep their reservations in Vail or Oahu: “If you do not give your clients an opportunity to do this, they’re going to be furious with you.’’

Tax Vox’s Lump of Coal Award: The Worst Tax Ideas of 2009

by Howard Gleckman

As 2009 draws to an icy conclusion, Tax Vox is pleased to announce its Third Annual Lump of Coal Award for the worst tax ideas of the year. So many choices. So little time.

10.  The Roth Rollover. Let’s see, allowing people to turn their tax-deferred retirement savings into fully tax-free investments starting on Jan. 1 will be a long-term fiscal catastrophe. And in the short run, the up-front taxes people must pay to roll into a Roth could depress the stock market and damage the shaky recovery. What’s not to like?

9. The Bo-Tax and the Tanning Bed Tariff. This is what happens when you need money and won’t talk seriously about revenues.

8. Obama’s Middle-Class. This is a rerun from last year, but it is too good to leave out. The President thinks we will somehow reduce the deficit and fix the tax code without raising taxes by a dime for those poor souls making a quarter million dollars-a-year or less. Unfortunately, that’s 95 percent of us. Can’t wait to see how he does it.

7. Taxing the Rich. Why not let a handful of wealthy taxpayers finance all your new ideas. So let’s drive the top rate north of 45 percent, even though no one will really pay it. On the other hand, except for Barbra Streisand and those other Hollywood types, they are mostly Republicans anyway.

6. The Estate Tax. Now you see it. Now you don’t. Wait, there it is again. So what if nobody has any idea how to do estate planning anymore. On the other hand, Congress has had only eight years to fix this mess.

4. California. It claims to be the fifth largest economy in the world but can’t pass a serious budget, and can’t govern itself. It is the poster child for dysfunctional state governments and fiscal crises everywhere

3. The homebuyer credit. Congress started the year by giving away $8,000 in subsidies to “first-time” homebuyers, as many as 74,000 of whom, it turned out, never quite got around to buying a house. Then, it extended the boondoggle to current owners who buy up. Bottom line: People who were already going to buy will get billions of dollars in government subsides. But you gotta make those real estate agents happy.

2. The Obama Tax Reform Panel. Not only will it fail to propose an improved tax code, it missed its own deadline. Nothing beats being both disappointing and late. “After the holidays,” the Obama people say. Does anybody care?

1. And the winner is, of course, the HAPPY Act. We’ve got a $1.5 trillion deficit and a Republican congressman named Thaddeus McCotter wants a $3,500 deduction for the cost of caring for our pets. Why? Because we love them.

More Tax Chores for the Wealthy at Year-End

Wealth Matters

By PAUL SULLIVAN
Published: December 11, 2009

At the end of every year, there is a basic list of things wealthy people should do to put their financial houses in order. But this year, that house may be a lot messier than in years past, given the wild swings in wealth in the last 12 months and the various government programs and proposals that can change the calculus.

Sam Petrucci of Credit Suisse Private Bank says a popular tactic has been a special annuity trust to give money to an heir tax-free.

The biggest question — the one that overshadows all of the others and is still unresolved — is what will happen to the estate tax next year. While the House of Representatives has voted to make permanent the current 45 percent tax rate on all estates above $3.5 million, the Senate has yet to take up the bill. And it is not clear if it will have time to do so this year.

The uncertainty gives wealthy investors much to consider in the next few weeks. To address these concerns, I intend to discuss here what you should do before the end of the year and use the next column to look at what you should do at the beginning of 2010.

NOW OR THEN?

The mantra for year-end tax planning is usually “accelerate deductions, delay income.”

The reason is simple: to lower your tax bill in that year. But with the prospect of higher taxes on the wealthy by 2011 at the latest, the advice now is the opposite: accelerate income now and delay deductions until after taxes rise, when they could be more valuable.

“Many people are resigned that income taxes are going to rise,” said Janine Racanelli, managing director and head of the Advice Lab at J. P. Morgan Private Bank. “People are being tactical as the picture is becoming clearer.”

What is certain is the income tax for the top earners is going to be 39.6 percent in 2011, up from 35 percent now.

Yet there are other variables, Ms. Racanelli said, that could drive tax rates even higher, like surcharges on those who make more than $250,000 a year and other taxes to pay for the health care legislation.

Some of the popular types of income being accelerated are stock options, distributions from retirement accounts for people over 59 ½ and payments from deferred compensation plans. Ms. Racanelli added that business owners were looking particularly closely at paying themselves dividends from their company. Their fear is that the tax on these qualified dividends may rise to the income tax rate, from the current 15 percent.

CAPITAL GAINS DECISIONS

Also unknown is what will happen to the long-term capital gains tax rate. Many advisers suspect it will rise to 20 percent, from 15 percent, by 2011. As a result, some investors are weighing whether to sell securities now and pay the lower capital gains tax.

Stephen Horan, head of private wealth at the CFA Institute, said it might not make sense to rush to sell, even if the rate went up. He has run calculations on the impact of an increase and said that if your investment horizon was 10 years, you needed to earn just 2 percent more per year to make up for a five percentage point increase in the capital gains tax.

“It’s better to keep your money than give it to the government,” he said.

Mr. Horan said investors could actually do even better by avoiding the higher short-term capital gains tax. That rate is 35 percent and is applied to investments held for less than 12 months. Over 10 years, investors could earn 15 percent more on their money by avoiding short-term capital gains, he said.

Of course, these taxes are paid only on gains. Most investors still have substantial losses left from 2008. If losses outweigh gains, people can deduct $3,000 from their taxes each year until that loss is used up.

SHORT-TERM TRUST

For the wealthy, this was the year of the GRAT, for grantor retained annuity trust. Sam Petrucci, a director in the wealth planning group at Credit Suisse Private Bank, said he arranged more of these trusts this year than at any time in the previous decade.

GRATs are a fairly simple way to transfer money to an heir tax-free. A person puts a sum in the trust that will be paid back to him over a fixed period of time. The heir receives any appreciation in the trust above a “hurdle rate” — the interest the Internal Revenue Service requires to be paid to the person who set up the trust.

The reasons for the increased attention in these trusts were twofold: the hurdle rates were low all year, as were the prices of some securities. Mr. Petrucci said that someone who put $10 million into a two-year GRAT with the December hurdle rate of 3.2 percent, assuming an 8 percent return, would pay himself two payments of roughly $5.2 million and pass $760,000 to heirs free of gift tax.

But it was the prospect of Congressional action that really touched off the interest in setting up short-duration GRATs before the end of the year, Mr. Petrucci said. One proposal would require a GRAT to be at least 10 years long. If the person setting it up died in that time, the money would revert to the estate. The second proposal would require the person setting up the trust to pay a gift tax on 10 percent of what he puts in. Currently, a person can “zero out the GRAT,” which means he pays himself back the full amount and nothing is taxed.

CHARITABLE EXPIRATION

The next Wealth Matters column will discuss the pros and cons of converting your pretax retirement account into a post-tax Roth Individual Retirement Account in 2010. Meanwhile, there is one I.R.A. provision that will expire this year unless Congress extends it. It is the charitable rollover provision, which allows someone to donate $100,000 directly from his or her retirement account to a public charity. The person doing this has to be over 70 ½ and the money has to be transferred directly from the I.R.A.

Jere Doyle, wealth strategist at Bank of New York Mellon, said the donor would not get a tax deduction, which he would get if he donated the money directly. But he would get the benefit of not having to pay ordinary income tax on that amount. The transfer also counts toward the minimum distribution from a retirement account, which the I.R.S. suspended for 2009 but may reinstate next year. “It’s a good way to clean out your I.R.A.,” he said.

HOUSING ISSUES

Two property-related benefits also need to be considered. The Mortgage Forgiveness Debt Relief Act was scheduled to expire at the end of the year, but it has been extended until 2012. Normally, a person has to pay ordinary income tax on the part of a mortgage the bank forgives. Under this law, up to $2 million will continue to be forgiven tax-free on a person’s primary residence.

The second issue is conservation easements. The wealthy use these to give part of their property to a local conservancy and get a tax break. Mr. Doyle said this is probably the last year that people can deduct an easement worth up to 50 percent of their adjusted gross income.

The Incredible Shrinking Estate Tax

by Bob Williams on Thu 22 Oct 2009 08:00 AM EDT
The estate tax is only a faint shadow of its former self. In 2009, less than one-quarter of one percent of deaths—just 5,500 decedents—will leave taxable estates, the smallest percentage since at least the Great Depression. In part, that tiny fraction reflects the current recession’s devastation of assets—the Fed estimates that the total value of household and nonprofit assets fell by about one-sixth between 2007 and the first quarter of 2009. But changes in estate tax rules over the past decade have played a much larger role than economic swings.

The Economic Growth Tax Relief and Reconciliation Act of 2001 (EGTRRA), best known as the Bush tax cuts, phases the estate tax out over a decade. The act raised the effective exemption incrementally from $675,000 in 2001 to $3.5 million in 2009 and dropped the top tax rate from 55 percent to 45 percent. The levy disappears entirely in 2010, only to return in 2011 under pre-EGTRRA law—a $1-million exemption and 55-percent top rate. The Obama administration has proposed making the 2009 parameters permanent and indexing them for inflation. Others would set a higher exemption and a lower tax rate.

So what’s happened?

For decades before 1976, only estates worth $60,000 or more owed estate tax. That threshold remained constant in nominal terms, so more and more estates had to pay the tax as economic growth and inflation boosted household wealth. In 1943, just under 1 percent of deaths led to estate tax payments; by 1976, that share had grown to 7.65 percent (see graph).

Congress doubled the effective exemption to $120,000 in 1977 and raised it gradually to $600,000 in 1987, where it stayed for ten years. As the exemption rose, the share of estates owing tax fell to just 0.9 percent in 1987 before growing again because of the fixed exemption. In 1997, when a bit more than 2 percent of estates owed tax, Congress again enacted a series of increases in the exemption that would have reached $1 million in 2006. Deaths resulting in estate tax liability stabilized until EGTRRA set off the latest inexorable drop in taxable estates.

So what’s next? The share of estates owing tax is scheduled to drop to zero in 2010, thanks to the one-year repeal. Except Congress won’t let that happen. Smart money says Congress will extend the 2009 law for 2010—a $3.5-million exemption and a 45-percent tax rate—and then consider a permanent fix when they deal with the scheduled 2011 sunset of almost all of the Bush tax cuts. Senators John Kyl (R-Az) and and Blanche Lincoln (D-AR) want to shrink the tax below its 2009 level—they want a $5-million exemption and a 35-percent tax rate.

Few lawmakers now call for total repeal, though such a proposal would surely get lots of votes. Opinion polls show significant numbers of voters saying they would more likely vote for a candidate who favors repeal. Maybe they all think they’ll win the lottery or their next great idea will become another Google. In the real world, we’re spending a lot of time worrying about a tax that fewer than three in a thousand of us will pay. And, when we do, we’ll be dead.

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