Federal Estate Tax Repeal: Planning Considerations

Author:
Adrienne M. Penta, Esq., Brown Brothers Harriman & Co.

The federal estate tax is gone (for now), but not forgotten. Congress failed to take action before the end of 2009, resulting in the “sunset” of the estate tax in 2010. Currently, there is no federal estate tax for decedents dying in 2010, and no federal generation-skipping transfer (“GST”) tax for GST transactions completed in 2010. The gift tax, however, remains in place at a rate of 35%. This sunset was enacted as part of tax legislation passed in 2001.

If Congress does not address transfer taxes before the end of the year, the federal estate tax will come back with a vengeance in 2011. The federal estate tax exemption amount will be $1,000,000—a significant reduction from the 2009 exemption amount of $3,500,000—and the top marginal rate will escalate to 55%—10% higher than the 2009 rate of 45%. In addition, there will be a 5% surcharge on estates exceeding $10,000,000. The GST tax will also return in 2011 with a $1,000,000 exemption amount and a rate of 55%, and the gift tax rate will revert to 45%. Many practitioners believe that Congress will enact estate and GST taxes for 2010 and make them retroactive to January 1, but right now, in the words of Senate Finance Committee Chairman Max Baucus, there is “massive, massive confusion.”

Although there are no readily available answers, to help sort through the confusion there are five issues listed below that estate planners should keep in mind when drafting and reviewing estate planning documents.

1. Formula Clauses. If no estate tax is enacted for 2010, many current estate plans may not accomplish the clients’ desired goals. Most plans for married couples written in prior years allocate as much property as can pass free of estate tax (i.e., the exemption amount) to the family or “credit shelter” trust and the remaining property to the marital trust. Under some formula clauses, in a no-tax environment, all of the estate’s assets may pass to the family trust. If the surviving spouse is not a beneficiary of the family trust, the decedent could unintentionally disinherit her spouse. The plans at greatest risk are likely those drafted for clients with children from a prior marriage and for individuals living in states with no state estate tax. Formula clauses determining bequests to charity should also be reexamined as they may not function as the client would desire if there is no federal estate tax.

2. Carry-Over Basis Regime. If Congress does not act, the current law imposes a carryover basis regime on decedents dying in 2010. Under the carry-over basis system, the basis of assets transferred at death will be the lower of (a) the decedent’s tax basis and (b) the fair market value of the asset on the date of death. For example, if a share of stock was bought by Dad in 1945 for $1, inherited by Daughter at a value of $75 and then sold for $100, the Daughter’s tax basis would be $1, and she would realize a capital gain of $99. This system requires everyone to track the cost basis of all assets. Further cost basis complications beyond the scope of this article may arise for decedents in states that impose a state estate tax.

3. Allocation of Basis Adjustment. Under the 2010 carry-over basis regime, each estate will receive a limited step-up in basis equal to $1,300,000. This “exemption” may be used to increase the basis of the estate’s assets to their fair market value, but no higher. In addition, $3,000,000 will be available to each estate to increase the cost basis of assets passing to the surviving spouse. To qualify for the spousal step-up in basis, however, the property must be either held in a marital trust that that meets the requirements for a QTIP or transferred outright to the spouse from the decedent. Many estate plans drafted in 2009 and prior years do not take this new carryover basis system into consideration, and if all of the decedent’s property is distributed to a family trust, the $3,000,000 spousal basis adjustment will be wasted. In addition, executors are required to allocate the basis adjustment on an asset-by-asset basis. Any person named as an executor should ask about the testator’s intent with respect to which assets and which beneficiaries should reap the reward of a stepped-up basis.

4. Taxable Gifts. Currently, the gift tax rate is 35%, reduced from 45% in 2009. If a client makes a taxable gift this year, he may pay gift tax at a rate of only 35%. It is possible, however, that Congress will raise the gift tax rate to 45% and apply that rate retroactively to all gifts made in 2010. Therefore, clients should be advised of the significant risk of relying on a 35% gift tax rate.

5. Gifts to Crummey Trusts. Finally, if Congress takes no action in 2010, grantors may be unable to allocate GST exemption to Crummey gifts made this year to insurance trusts and other irrevocable Crummey trusts that are intended to be wholly GST exempt. Although the GST tax treatment of these gifts is unclear when the GST tax returns in 2011, one possibility is that the trust would have an inclusion ratio between zero and one due to the non-exempt 2010 Crummey gifts. If so, the grantor would have to make a late allocation of GST exemption to make the trust wholly GST exempt. Alternatively, for an insurance trust, the grantor could lend the trust enough assets to make the premium payments in 2010 and avoid the GST issue; however, the grantor may not have enough annual exclusion gifts in the following year both to (i) pay that year’s insurance premiums and (ii) repay the loan.

Good luck!

Legislative Update: Massachusetts Uniform Trust Code (“MUTC”)

Authors: Matthew R. Hillery, Esq., Edwards Angell Palmer & Dodge LLP
Suma V. Nair, Esq., Goulston & Storrs, P.C.

In 2000, the Uniform Law Commission promulgated a Uniform Trust Code for consideration by the states. In 2005, an Ad Hoc Committee of Massachusetts attorneys convened to review the Uniform Trust Code in detail. That Committee has described the Uniform Trust Code as an attempt to codify the rules relating to trusts comprehensively and uniformly and in some cases to include innovative provisions thought to improve upon the common law.

In reviewing the Uniform Trust Code, the Ad Hoc Committee (1) evaluated current Massachusetts law, preserving it where the committee thought it was superior to the Uniform Code and (2) in some cases, rebalanced the power between the beneficiaries, the trustee and the settlor where the Committee disagreed with the balance struck in the Uniform Trust Code. The eventual product of the Ad Hoc Committee was the MUTC. The MUTC would concentrate in one place the Massachusetts statutory law of trusts, which should make it easier to know the law. The MUTC would supersede the Massachusetts common law of trusts to the extent that they are inconsistent.

The Steering Committee of the Boston Bar Association’s Trusts and Estates Section has voted to support enactment of the proposed Massachusetts Uniform Trust Code (“MUTC”). The Steering Committee’s vote followed an approximately two month review period that included an open discussion meeting on January 22, 2010, in which all members of the Section were invited to participate. Most of the members of the Ad Hoc Committee that drafted the MUTC participated in the January 22 discussion. While a majority of the members (15) of the Steering Committee voted to support enactment of the MUTC, a minority of the members (3) voted not to support enactment of the MUTC at this time. A summary of each of the majority view and the minority view follows:

Majority View. The Uniform Trust Code, with state specific modifications, has been adopted by 23 states to date, including New Hampshire, Vermont and Maine. As with any uniform statute, a primary purpose of the Uniform Trust Code is to make the administration of trusts more uniform among the states, a reasonable goal in the 21st Century given that trust law in most states, including Massachusetts, is based largely on case law. Adoption of the MUTC will be seen favorably as moving Massachusetts into the modern era of trust law and administration. The Ad Hoc Committee that drafted the MUTC was comprised of well-regarded members of the Massachusetts Bar who debated each section of the uniform statute. The result of that debate, which included whether or not the MUTC is even needed, is a statute that will (in the words of the Ad Hoc Committee) “simplify and make more accessible the law of trusts in Massachusetts while leaving our vast common law on the subject largely intact.” The Committee’s Report includes an extensive introductory section and comments on each section of the proposed MUTC. The MUTC has been endorsed without any recommended changes by the Probate Section of the Massachusetts Bar Association and by the Massachusetts Bankers Association.

Minority View. A small group of the Steering Committee voted against approval of the draft MUTC at this time. The main concern was that the act is moving forward too quickly and that its possible effects had not been fully considered by members of the Section and of the bar. The act explicitly changes many long-standing rules that have been relied on in the formation and administration of trusts in Massachusetts (for instance, by changing the current default rule requiring unanimity among trustees) and introduces new rules and requirements not previously seen. Most of these changes are applied to all trusts, regardless of when created or made irrevocable. Furthermore, some members felt that the Committee Report should be expanded to explain more fully the rationale behind the proposed changes to Massachusetts law and to the model UTC.

The Steering Committee has already voted to approve the draft MUTC, but the legislative process has only just begun. We urge those of our members who have not yet had the opportunity to review the draft act and committee report to do so now. We welcome your comments.

An Act Further Regulating the Rights of Adopted Children and its Impact on the Trusts and Estates Bar: An Update

Author:
Marc J. Bloostein, Ropes & Gray LLP

In the Spring 2009 Newsletter I reported on chapter 524 of the Acts of 2008, which went into effect on April 15, 2009. That new law, called “An Act Further Regulating the Rights of Adopted Children,” changed the effective date of the current rule of construction applicable to terms like “child”, “grandchild” and “issue” in wills, trusts and similar instruments executed before August 26, 1958. The current rule of construction is found in G.L. c. 210, § 8 and presumes that adopted descendants are included in such class gifts (I will refer to this as the “Modern Rule”). The Modern Rule’s original effective date provision limited its application to instruments executed on or after August 26, 1958. The prior rule of construction, which presumed inclusion of persons adopted by the testator or settlor and presumed exclusion of persons adopted by others, continued to apply to pre-1958 instruments. Chapter 524 made the Modern Rule applicable to all instruments, whenever executed, excepting from its application only distributions under “testamentary instruments” made before May 1, 2009.

Chapter 524 came as a complete surprise to members of the trusts and estates bar, who had relied on the longstanding effective date rules in advising clients. As a result of the efforts of the Boston Bar Association, the Massachusetts Bankers Association and others, the Legislature temporarily repealed chapter 524 in the June budget bill, reinstating the old effective date rule for the period from July 1, 2009 to July 1, 2010. St. 2009, c. 27, §§ 101-102 and 159-161. The chapter 524 replacement, which will become effective July 1, 2010, reads as follows: “Section 8 of chapter 210 of the General Laws shall apply to all grants, trust settlements, entails, devises, or bequests executed at any time, but this section shall not affect distributions made before July 1, 2010 under testamentary instruments executed before September 1, 1969.” St. 2009, c. 27, § 102. (The 1969 date relates to the effective date of the current effective date provision of G.L. c. 210, § 8.)

The good news is that this development postpones application of the Modern Rule to pre-1958 instruments until next July. The bad news is that the chapter 524 replacement retains the same unclear limitation that prevents the Modern Rule from applying retroactively to distributions made before July 1, 2010 only with respect to distributions under “testamentary instruments.” This leaves open the question of whether the Modern Rule will be applied retroactively to distributions made today under pre-1958 instruments that are not “testamentary instruments.”

Generally, the word “testamentary” pertains to a will or similar document that disposes of property at a person’s death. According to Black’s Law Dictionary (6th ed. 1990), a testamentary instrument is “[a]n instrument in the nature of a will; an unprobated will; a paper writing which is of the character of a will, though not formally such, and, if allowed as a testament, will have the effect of a will upon the devolution and distribution of property.” So, the term clearly includes a will and a trust established under a will. One could argue that it includes a trust established under an inter vivos instrument that took effect at a person’s death (i.e., a revocable trust), on the theory that such an instrument is a will substitute and transfers property at death. However, it would be hard to treat a typical irrevocable inter vivos trust as a testamentary instrument. Such a trust might be established for one or more children or grandchildren, and would take effect immediately and not at the time of the settlor’s death.

If a trustee is administering a pre-1958 trust established under a will, then the chapter 524 replacement clearly does not apply the Modern Rule to any distributions made prior to July 1, 2010. If, however, a trustee is administering a pre-1958 irrevocable inter vivos trust, there is nothing in the chapter 524 replacement to suggest that the Modern Rule will not be applied retroactively to prior distributions. It would be sensible to read “testamentary instruments” very broadly, but a court cannot ignore entirely the language the Legislature chose.

Of course, it would be difficult to argue that a trustee should be responsible for making a distribution in contravention of the new effective date of the Modern Rule prior to the trustee having reasonable notice of it. So, an adopted individual who by virtue of the new effective date will become a beneficiary of an inter vivos trust would likely have a difficult time arguing come July 1, 2010 that she should have received distributions going back to the inception of the trust long before 2009. However, that same beneficiary might have a claim come July 1, 2010 with respect to distributions made today under an inter vivos trust because arguably by today a trustee should be on notice that the Modern Rule will be apply retroactively to the trust starting next July. A trustee administering a pre-1958 inter vivos trust with a potential adopted beneficiary should at least consider retaining from any current distribution sufficient assets to pay an adopted beneficiary come July 2010.

Another aspect of this legislative development relates to events that occurred between April 15 (when chapter 524 became effective) and July 1, 2009 (when that statute was repealed). The June legislation stated that the temporary repeal of chapter 524 “shall [not] affect the validity of any action taken pursuant to chapter 524 of the acts of 2008 between April 15, 2009 and [July 1, 2009].” St. 2009, c. 27, § 159. Clearly any distributions made to an adopted beneficiary under color of chapter 524 were not affected by the new law. But what if a pre-1958 trust terminated during the period and the beneficial interests vested though no distribution was made? There’s a strong case to be made that the termination date is the relevant date and the distribution should include adopted beneficiaries even if made after July 1, 2009. The answer, however, is not entirely clear from the statute. It is also possible that an adopted person who became a discretionary beneficiary of a trust on April 15, 2009 could argue that the temporary repeal deprived her of her beneficial interest in violation of her due process rights. There would not, however, be much support for such an argument as there would have been little reliance on her very short-term status as beneficiary.

There are still many questions to be answered in connection with chapter 524 and its replacement. In addition to the interpretational questions, there may well be an effort to repeal the statute, and there will likely be one or more constitutional challenges to the statute.

New Rule Eliminates Income Limits for Roth IRA Conversions

Author:
Michelle Addison, Bingham McCuthchen LLP

Enacted in 2006, the Tax Increase Prevention and Reconciliation Act eliminates the existing $100,000 modified adjusted growth income cap for converting a traditional individual retirement account (IRA) to a Roth IRA starting on January 1, 2010. While the conversion from a traditional IRA to a Roth IRA is treated as a taxable distribution, the taxpayer may choose to pay income tax on the entire converted amount in 2010 or have one-half of the taxable converted amount taxed in 2011 and the other half in 2012. The client also has the option of converting in installments over a number of years to take less of a one-time tax hit, instead of converting the entire IRA in 2010.

The major benefit of converting to a Roth IRA is that earnings and withdrawals are income tax-free so long as the individual (i) has held the Roth IRA for a minimum of five years from the date of conversion and (ii) is at least age 59½ at the time of withdrawal. Roth IRAs also have no required minimum distributions after age 70½. In addition, by paying the income tax on the IRA upon conversion, the client’s taxable estate would be reduced by the amount of income tax paid—in Massachusetts, this should be advantageous even after taking into account the IRD deduction allowed traditional IRAs under Section 691.

All other things being equal, in deciding whether to convert to a Roth IRA, a primary consideration is the client’s marginal income tax bracket—both the current rate and estimated future rate. If the client’s predicted future tax bracket is lower than his or her current marginal rate, conversion might be less attractive than it would be if tax rates or the client’s income were predicted to increase. If the client’s current and future marginal income tax brackets are the same, then a converted Roth IRA should produce the same amount of wealth as a traditional IRA after the payment of income taxes. Of course, all situations are unique and clients should consult legal counsel and/or financial advisors to determine if conversion is advisable for them.

Another concern is whether the client will be able to pay the taxes resulting from the conversion without dipping into the IRA’s assets. Conversion may not make sense for a client if he or she cannot pay the taxes from an independent source of funds. If a client converts a traditional IRA to a Roth IRA but reserves a portion of the IRA funds to pay the tax, the 10% early withdrawal penalty will also apply if the client is under age 59½. Therefore, for younger clients unable to pay the income tax from non-IRA assets, a Roth conversion may not be efficient.

The recent market decline, which has resulted in lower value of many IRAs, makes conversion attractive as the tax cost is reduced. Conversion will also protect the IRA from any future tax increases. After careful analysis of each client’s estate and income tax planning considerations, 2010 may be a good year to convert for many.

10 Tips on Community Property for the Common Law Estate Planner

Authors:
Leiha Macauley, Day Pitney LLP
Kate Hilton, Hauser Center for Nonprofit Organizations

1. History and Policy: Community property law developed from Germanic tribal practices introduced in Spain following the fall of the Roman Empire. In the United States, the Spanish system was retained in territories acquired from Spain, Mexico, and France. On admission to statehood, several southwestern states adopted community property statutory provisions. Other states, having no substantial contact with Spanish culture or institutions, nevertheless adopted the community property system to attract women as settlers and provide for women’s property rights, because community property is a commitment to the equality of spouses. It treats marriage as a partnership in which spouses devote their particular talents, energies, and resources to their common good, and acquisitions and gains that are directly or indirectly attributable to partners’ expenditures of labor and resources are shared equally.

2. Geography: In the following eight states, the community property system is mandatory for residents unless they enter into an agreement opting out of the system.

Arizona Idaho New Mexico Texas

California Louisiana Nevada Washington

Although a number of community property rules are applicable among the community property jurisdictions, considerable local variations exist. Note also that Wisconsin is a default community property regime, though couples may “opt-out”; and Alaska permits couples to “opt-in” to a community property regime.

3. Community property vs. separate property vs. quasi-community property: Community property is all property acquired by either spouse during marriage while domiciled in a community property state, excluding property received by gift or inheritance. Community property provides each spouse a one-half, undivided, legal or equitable, vested or contingent, present or future interest in the property. Separate property refers to property acquired before marriage or property acquired after marriage by gift, bequest, devise or inheritance. Quasi-community property treats acquisitions of property made outside the state that would have been community property had they been acquired in-state as community property. Quasi-community property laws were designed to protect a nonmonied spouse following a move from a common law state to a community property law state.

4. Characterizing Community Property: Title is generally irrelevant to the characterization of property in community property states. Rather, the presumption is that a married couple owns all the property that they acquire during marriage as community property. This presumption can be rebutted only by strong proof to the contrary, referred to as “tracing.” Unless separate property can be traced, commingling community and separate property generally results in all commingled property being considered as community property.

5. Step-Up (or Down) in Basis: Under federal income tax law, all community property receives a new basis at the death of the first spouse to die equal to the property’s then fair market value, even though only the decedent’s one-half community property interest is included in his gross estate. The basis adjustment for the survivor’s interest in community property is a unique advantage that has no counterpart in common-law states.

6. Tangible Property vs. Real Estate: The character of tangible property is fixed at the time of acquisition in accordance with the law of the marital domicile, whereas the character of real property is generally determined by the law of the real property’s situs. For example, real property located in a community property state owned by spouses who reside in a common law state is generally considered community property.

7. Estate and Gift Tax: Community property automatically equalizes estates between spouses. Because each spouse owns one-half of the property, each spouse can dispose of only one-half of the couple’s community property at death. When the first spouse dies, his or her gross estate includes one-half of each and every item of the couple’s community property. Community property allows both spouses to take full advantage of their estate, gift and GST exemptions without re-titling assets.

8. Conflict of Laws, Federal Preemption and International Jurisdictions: Generally, the law of the matrimonial domicile governs in ascertaining the rights which each party acquires in the property of the other, except when federal laws preempt state laws. For instance, ERISA preempts application of a state’s community property laws to an ERISA-governed pension plan. Also beware that property located in foreign countries following a community property regime generally retains its community property nature even after the couple moves to a common law country or state.

9. Planning for Clients Moving from a Community Property State to Massachusetts: When spouses relocate from a community property jurisdiction to a common law property jurisdiction, the couple’s rights and interests in property that can be moved will be governed according to the law of the spouses’ marital domicile at the time of acquisition. It is advisable to: (1) determine community property assets with a written inventory; (2) ascertain whether clients have a community property agreement that characterizes assets as separate; (3) protect the double basis step-up; and (4) develop a plan to preserve community property (or re-characterize it as separate property).

10. Planning for Clients Moving from Massachusetts to a Community Property State: Most pre-existing assets will be viewed as quasi-community property, while assets that begin to accumulate from spouses’ personal efforts after the move are automatically community property. Remember that commingling separate and community property taints the character of separate property because the presumption is that all property is community property. To avoid this issue, consider transmutation. Transmutation is an interspousal agreement that alters the character of the property through a written statement that the ownership of the property is altered. Before the move, it is advisable to: (1) ask for an inventory of all property at the time of relocation (which thereby provides an itemized list of all of the spouses’ separate property); (2) advise spouses to maintain separate checking and savings accounts to avoid and/or trace any commingling; (3) suggest that clients develop a practice of maintaining basic records noting the source of funds to pay for major investments; and (4) determine whether the spouses wish to enter into a post-marital agreement. Pre- and post-marital agreements provide clarity and limit disputes when the rights of the spouses change after changing domicile from a common law state to a community property law state during marriage. Pre-marital agreements entered into by spouses residing in a common law property jurisdiction are cause for concern if they do not take into account a future move to a community property jurisdiction. Spouses moving to a community property jurisdiction who are interested in preserving the separate nature of property are advised to enter into a post-marital agreement fixing the character of that property.