Dedon on Estate Planning

Life Insurance

Many clients rely on life insurance as part of their estate plan.  Indeed, for clients with taxable estates, it is difficult to plan without using life insurance to pay estate taxes.  Life insurance is particularly important if the assets are illiquid, such as real estate or a closely held business, and the estate tax needs to be paid within nine months of death.

Life insurance can be purchased so that the entire amount of the death benefit is received by the beneficiaries estate tax free. For example, under current law, if a husband and wife have assets worth $7 million exclusive of life insurance, and they have a $3 million life insurance policy in an irrevocable trust, the children receive $10 million estate tax free.  This assumes the assets are positioned properly to take advantage of each spouse's $3.5 million exemption and the irrevocable trust is the original owner of the policy.

When creating an irrevocable trust, several complicated issues arise that are the Trustee's responsibility.  If the Trustee is a family member unfamiliar with the legalities of irrevocable trusts, professional guidance is necessary.  Issues relevant to the Trustee include (1) is a Trust account opened by the Trustee to receive premium payments; (2) assuming the grantor pays the premium, is the payment protected by the annual exclusion; (3) the answer to (2) above often depends on whether "Crummey letters" have been prepared, qualifying the premium payment for the annual exclusion.

The Trustee also is responsible for making sure the policy is performing properly, e.g., are the policy assumptions pertaining to interest and mortality rates appropriate?  Also, the Trustee must determine if the insurance carrier is still a strong company.

Using an Irrevocable Trust to own life insurance provides significant advantages.  However, the advantages come with some complication; namely, choosing the right Trustee.  If the Trustee is not an institution or professional, the Trustee must know where to turn for help in dealing with a myriad of issues.

Estate Tax Legislation

Inquiring minds want to know:  what is the latest in Congress on estate tax? All tax legislation must come from the House Ways and Means Committee, and two news items came out of Ways and Means last week.

First, Chairman Charles Rangel, despite his own problems and contrary to earlier statements, said he is drafting a bill to make the $3.5 million exemption permanent. In the past, Rangel said he favored extending the $3.5 exemption amount one year and addressing it again in 2010.

Second, two other Ways and Means Committee members introduced legislation to increase the exemption to $5 million over the next 10 years, plus index the amount for inflation. This bill would also lower the estate tax rate from 45% to 35%.

As you know from reading this Blog and other publications, if the estate tax law is not addressed the exemption amount will fall to $1 million with a maximum 55% tax rate in 2011. The estate tax would disappear entirely for one year, 2010. Hence, the estate tax system is a Congressional priority, notwithstanding all the other issues Congress is now facing.

Besides dealing with the exemption amount and the tax rate, there are other important estate issues before Congress. For example:

• the issue of "portability," i.e., the ability of a married couple to protect $7 million without having to carefully arrange asset titling and beneficiary designations prior to their deaths.

• whether Congress should curtail certain advanced estate planning tools, such as being able to discount for tax purposes the value of intra-family gifts and the use of 2-year GRATS.

(I have written in prior posts on portability, discounting and GRATS.) As of now, it is anticipated that none of these subjects will be addressed this year.

Settling Tax Issues with the IRS

The IRS is gearing up its tax compliance efforts after a few years of reduced activity. One indication of these increased efforts is the recent hiring of 400 new IRS Appeals Division employees. The IRS now has roughly the same number of Appeals Officers that existed a decade ago. As professionals who deal with the IRS know, the Appeals Division is the second layer of IRS review for taxpayers whose estate and income tax returns are audited.

The first level is the audit level, where the agent is likely to view issues from the IRS perspective. If matters cannot be settled at the audit level, the next step is typically the Appeals Division. The Appeals Officer is supposed to consider the "hazards of litigation," meaning rather than take a biased IRS view, the Appeals Officer should consider the legal issues supporting each side and strive to reach a reasonable settlement. As Kurt Meier, deputy chief of the Internal Revenue Service's Appeals division recently said at an American Bar Association luncheon, Appeals must provide an "impartial, fresh look." It has been my experience that most Appeals Officers subscribe to this view.

Therefore, often taxpayers who settle their tax problems with the IRS will do so at the Appeal level, not at the audit level with an agent. Settling at the Appeals level avoids the added cost and time involved in Tax Court litigation. For this reason, having adequate Appeals Officers on board is not bad news.

Charitable Contribution Deductions

Many donors are confused whether they can claim a charitable income tax deduction for gifts directly to individuals. Even if the donee is poor and in need, a contribution directly to that individual does not necessarily result in a charitable contribution deduction.

Some background: Generally only contributions to charities are tax deductible. The IRS determines whether an organization is a qualified charity. Charitable organizations are generally two kinds: (1) public charities, such as universities, churches, relief organizations such as the Red Cross and the United Way, and most hospitals, or (2) private foundations. While public charities receive much of their support from many donors, private foundations are typically created by individuals and receive support from a limited number of people, such as from one family. So if Mom and Dad create a charity and they are the sole contributors that charity will be private foundation.

Although contributions to both public charities and private foundations are tax deductible, public charities enjoy more advantages. For example, a private foundation must distribute 5% of its assets annually. If 5% of its assets are not distributed, then taxes are imposed.

So back to my earlier point: if Mom and Dad create their own private foundation and it is approved by the IRS, that foundation cannot make distributions directly to individuals unless the foundation receives IRS approval for such specific grants. Thus, it is not sufficient to receive IRS approval for the foundation; the IRS also must bless the contributions directly to the donee-individuals. Mom and Dad must tell the IRS they intend to offer scholarships or grants directly to individuals. Mom and Dad must tell the IRS the criteria for selection, the potential grantees, who will do the selection, and other information. The IRS wants to make sure the donees are not, for example, Mom and Dad’s family. On the other hand, if Mom and Dad’s IRS approved private foundation distributes directly to a public charity, no prior IRS approval is required for the distribution.

In sum, when you donate to your church or your university and don’t receive anything in return, you obtain a charitable contribution deduction. However, if you create your own charity you need to obtain IRS approval as a private foundation and additional IRS approval if your private foundation intends to give directly to individuals. No contribution deduction is allowed for contributions directly to individuals that do not flow through qualified charities.

Estate Tax Legislation?

Is this the week Congress establishes certainty in the estate tax law? Probably not but talks are ongoing.

According to House Ways and Means Committee Chairman Charles Rangel, Committee members this week are continuing to discuss how to avoid the one-year elimination of the estate tax. Under current law, there would be no estate tax in 2010 but in 2011 the estate tax would return and cover estates exceeding $1 million at maximum tax rates of 55%. Currently, there is a $3.5 million exemption amount. For married taxpayers who do the proper planning, they can double the exemption amounts ($2 million in 2011 and $7 million in 2009).

It is difficult to plan not knowing whether the estate tax exemption will be extended at the $3.5 million level; whether it goes away temporarily or permanently; whether the exemption is reduced to $1 million; or an entirely unknown alternative. Rangel was quoted last week by the Publisher, BNA, that he favors a one-year extension of the $3.5 million amount rather than a "permanent" solution. President Obama has said he believes $3.5 million is the appropriate amount. On the other hand, Republicans still believe that a greater exemption amount and a lower estate tax rate is appropriate.

My prediction is that Congress will, as Rangel said, extend the $3.5 million exemption for one year, meaning we will have the same uncertainty for at least one more year. The problem would then again have to be addressed 2010. We will know soon.