02/28/2005 E-Alert – Joint Committee on Taxation Proposes Tax Law Changes Effecting Estate Planning

On January 27, 2005, the Congressional Joint Committee on Taxation (JCT) released a 435 page report entitled “JCS-02-05 Options to Improve Tax Compliance and Reform Tax Expenditures.” Assuming that the estate tax is not repealed, the following proposals contained in the JCT report may be enacted in order to tighten up several estate planning strategies the IRS has viewed as abusive.

On January 27, 2005, the Congressional Joint Committee on Taxation (JCT) released a 435 page report entitled “ JCS-02-05 Options to Improve Tax Compliance and Reform Tax Expenditures.” Several key members of Congress have voiced a willingness to back away from complete repeal of the estate tax in favor of raising the amount that can be passed estate tax-free to a higher amount, perhaps $3 million to $5 million. In 2003, federal estate taxes generated approximately $20.6 billion, the majority of which was paid by 3,486 estates of $5 million or more. Based on that figure, complete repeal of the estate tax could be viewed by the public and their representatives as being a significant annual gift to only the richest 3,500 families in the United States. Assuming that the estate tax is not repealed, the following proposals contained in the JCT report may be enacted in order to tighten up several estate planning strategies the IRS has viewed as abusive.

Generation Skipping or Dynasty Trusts. Section XI, Part A, of the report, entitled “Limit Perpetual Dynasty Trusts” states that Dynasty Trusts are inconsistent with the objective of imposing a transfer tax once every generation and that existing law provides unequal treatment since only some states have repealed the Rule Against Perpetuities. By allocating GST exemption to a Generation Skipping Trust or Dynasty Trust, taxpayers currently have the ability to pass assets down multiple generations free of gift, estate and generation-skipping transfer taxes for a period of hundreds of years of more. The JCT proposal would limit the GST exemption to one generation.

The JCT proposal would subject assets in a Generation Skipping Trust or Dynasty Trust passing from a grandchild to the grandchild’s children to the generation skipping transfer tax. Generation Skipping Trusts created before the enactment of laws proposed by the JCT would continue to benefit multiple generations free of gift, estate and GST tax.

Discounts on Family Limited Partnerships and Family Limited Liability Companies.Section XI, Part B, of the report, entitled “Determine Certain Valuation Discounts More Accurately for Federal Estate and Gift Tax Purposes” states that under present law valuation discounts can significantly reduce the estate and gift tax values of transferred property.

Under current law, a taxpayer may (a) make a gift of a minority interest and claim lack of control discounts even though the taxpayer or the taxpayer’s child controls the property being transferred, (b) contribute marketable securities to a partnership that he controls, and (c) at death, claim marketability discounts even though heirs may be able to liquidate the entity and thereby recover the full value by accessing the underlying assets.

Under existing law, each family member’s interest in a FLP or FLLC is considered separately for valuation purposes. Consequently, when valuing the interest of a particular family member, the extent of ownership by the remaining family members is irrelevant.

For example, if mom and dad gave away 51% of the ownership interest in a FLP or FLLC to their children while retaining a 49% interest in the entity, the fact that the taxpayers’ immediate family owned 100% of the entity would have no bearing on the valuation of the 49% retained interest in the FLP or FLLC.

The JCT report includes a “transferee aggregation rule” that would aggregate mom and dad’s 49% interest with the interests of the other family members that received FLP or FLLC interests. If the transferee aggregation rule results in the taxpayer having a controlling interest, then little or no valuation discount would be permitted for the FLP or FLLC interests being transferred during life or at death. The effective date of the transferee aggregation rule would be for transfers during life or at death occurring on or after the date of enactment.

Crummey Powers. Section XI, Part C, entitled “Curtail Use of Lapsing Trust Powers to Inflate the Gift Tax Annual Exclusion Amount” states that certain arrangements using Crummey powers have extended the “present interest” concept far beyond what Congress originally contemplated.

Currently, irrevocable life insurance trusts and other similar trusts have the ability to take advantage of annual gift tax-free gifting by providing lapsing withdrawal powers known as Crummeypowers in the trust document.

The JCT suggests three options that Congress should consider: (a) the beneficiary of a Crummeypower must be a direct, non-contingent beneficiary of the trust; (b) powers to withdraw trust assets can only be considered for gift tax purposes if they cannot lapse during the powerholder’s lifetime; or (c) withdrawal powers will only be taken into account if (i) there is no arrangement or understanding not to execute the withdrawal power and (ii) at the time of creation of the withdrawal powers a meaningful possibility existed that the withdrawal power would be exercised.

The first alternative would be effective for any transfers after the date of enactment and the other two alternatives would only be applicable to trusts established after the date of enactment.

Section 529 College Savings Plans. Section XI, Part E, entitled “Modify Transfer Tax Provisions Applicable to Section 529 Qualified Tuition Accounts” states that assets transferred to a 529 Plan would generally not qualify as a completed gift and would be included in the owner’s gross estate for estate tax purposes.

Currently, with some exceptions, the owner of a 529 Plan of which he or she is not the beneficiary is entitled to exclude the value of the 529 from his or her estate, even though the owner retains significant control over the account, including the ability to take assets back (subject to a penalty). Furthermore, Florida and other states provide that the assets of a 529 Plan are exempt from the creditors of the owner.

The JCT proposes that a gift to a 529 plan would not be a completed gift at the time of transfer and to the extent there are assets remaining in the 529 Plan at the owner’s death, the value of the 529 Plan would be included in the owner’s estate. These new provisions would be effective only for contributions (and earnings thereon) made in taxable years beginning after the date of enactment and would not apply to contributions (and earnings thereon) made on or before the date of enactment, as long as a separate accounting is made.

Time to Take Action?

It is impossible to say at this time whether Congress will repeal the estate tax or instead keep the estate tax in place and enact one or more of the JCT’s recommendations. However, these proposals should provide incentives for many taxpayers with potentially taxable estates who have been contemplating one or more of these estate planning strategies to act now, before any potential enactment. Our office is available to discuss the viability of any of these strategies, as well as other advanced estate planning strategies, with you and your clients. Contact us to schedule your appointment today.