On May 11 the Treasury Department released its “2009 Green Book”, General Explanations of the Administration’s Fiscal Year 2010 Revenue Proposals. These are the tax hikes the Obama Administration wants to help pay its health care changes.
The tax hikes include $24 billion more in estate and gift taxes over the next decade. An earlier story talked about changes affecting life insurance.
Remember that these are just proposals; Congress may not accept them. However, those who have thought about creating GRATs or taking advantage of valuation discounts may want to act sooner rather than later, lest the window of opportunity close.
The proposals do not mention changes in the estate tax exemption amount. In 2009, you leave a $3.5 million estate and pay no estate tax. The estate tax will disappear on January 1, 2010 and then, one year later, revert to what it was in 2001. If that happens, you’ll pay taxes up to 55% on estates larger than $600,000.
Changes in Valuation Discounts
Current Law
When you transfer property to others, either at death or during life, you generally pay estate or gift tax based on the property’s value. The lower the value, the lower your tax bill. ‘Estate freezes’ (and similar techniques) try to reduce the taxable value of property you give to family without reducing the property’s economic value.
Changes in tax law over the past couple decades have made estate freezes less attractive by ignoring “applicable restrictions.” These are restrictions that would normally justify valuation discounts because of a lack of marketability and control. They apply primarily to interests in a family business given to other family members. Appraisers must ignore those restrictions, which means the taxable value of the interest is often higher than what someone outside the family would pay.
Reasons for Change
Court decisions and changes in most state laws mean that many restrictions are no longer “applicable restrictions.” As a result, changes Congress made to discourage estate freezes and similar valuation discount techniques no longer have the same impact. The IRS has also identified other arrangements designed to avoid these laws.
Proposal
This proposal creates a new category of restrictions called “disregarded restrictions.” They would apply if – after the transfer – you or your family can remove the restriction or if the restrictions will lapse. You would have to ignore these restrictions when you value an interest in a family business that you transfer to family members. Instead, you would have to value the interest using assumptions the IRS will provide in future regulations.
Disregarded restrictions would include:
- Limitations on a holder’s right to liquidate that holder’s interest that are more restrictive than a standard identified in regulations.
- Any limitation on a transferee’s ability to be admitted as a full partner or holder of an equity interest in the entity.
The proposal also creates an artificial rule that says certain interests held by nonfamily members (including charities) are treated as owned by the family.
The IRS could issue regulations that create safe harbors that avoid the new rules. It could also make changes affecting how these proposals interact with the marital and charitable deductions.
The changes would apply to transfers of property subject to Section 2704 made after the date the new law is enacted. It will increase taxes by $19 billion.
Minimum Term for Grantor Retained Annuity Trusts (GRATS)
Current Law
A GRAT is an irrevocable trust. You put property into the trust and keep the right to receive income. GRATs usually end after paying income for a specific number of years. When the trust ends, property in the trust goes to family.
The value of the property you put into the trust (minus the present value of your retained income if that interest is ‘qualified‘) is a taxable gift to your family.
A fixed annuity is a qualified interest. It pays you a specific dollar amount each year.
Generally, you put property into the GRAT you believe will grow in value. When the trust ends, property in the trust goes to your family. Because you paid gift tax when you set the trust up, when you die the trust is not included in your estate. Your family gets the growth of the trust without you paying gift tax and without them paying estate tax. The more growth, the more gift and estate tax saved.
If you die before the GRAT ends, the property in the trust (or at least what is needed to pay the income) is included in your gross estate. Again, however, there is a tax-free transfer of any growth. Typically you try to time it so the GRAT ends before your life expectancy.
Reasons for Change
Taxpayers have become more adept at maximizing the benefit of this technique, often by reducing how long the GRAT lasts. This reduces the risk that you will die before the trust ends. Some trusts end in as little as 2 years. Some taxpayers retain such large annuity interests that the gift tax value of the remainder interest is zero or at least so small that there is little gift tax owing.
In other words, the IRS thinks GRATs are just too good to be true – or at least too good to let them continue unchanged.
Proposal
This proposal would require that GRATs last at least 10 years. This won’t prevent “zeroing-out” the gift tax value of the remainder interest. It will, however, increase the chances that you will die before the GRAT ends and that, the government hopes, means the IRS can collect more taxes.
This proposal would apply to GRATs created after the date of enactment and would give the government another $3.25 billion to play with.
Require Consistency in Value for Transfer and Income Tax Purposes
Current Law
Current law provides a step up (or step down) in basis when a person dies. The new basis is normally the property’s fair market value when the owner dies. The owner’s estate reports the same value for estate tax purposes. Current law does not, however, explicitly say the recipient must use the same value for his basis.
For lifetime gifts you use a carryover basis. That is your basis plus any gift tax paid when you make the gift. However, if the property is worth less than its basis, the recipient’s basis, for calculating any later loss, is limited to the actual value.
When you receive income from a trust or estate, the trust or estate reports taxable income on a Schedule K-1. You must use those same numbers when you file your income tax return. Schedule K-1 does not include basis information.
Reasons for Change
It’s easier for the government if everyone uses the same numbers when they file tax returns. That is, if you receive property from an estate, it wants you to use as your basis the same value the estate reported. The executor or donor is in the best position to make sure that others get information they need to determine basis.
Proposal
The executor or donor would be required to report needed information to the recipient and to the IRS. Treasury will develop rules for estates that don’t file returns and for small gifts. It would also provide rules for situations where a surviving joint owner or someone else may have better information than an executor and for similar situations.
The proposal would be effective from the date of enactment and will increase taxes by $1.9 billion.
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