Volume XX, Number 1 – JANUARY 2011
© Donlevy-Rosen & Rosen, P.A.
INTRODUCTION. More than 10 years ago we wrote an issue of the APN on estate freeze planning (Vol. IX, No. 1). The essence of estate freeze planning is just what it sounds like: the value of an asset (or assets) is “frozen” at today’s value for future estate tax purposes. A brief example will illustrate the effect of this strategy: The value of your asset worth $1million today is “frozen” using this technique. You pass away, say, 15 years from now at a time when that asset is worth $10million. The effect of the estate freeze is that $9million in appreciation will pass to your heirs free of estate tax. A new estate freeze planning opportunity has arisen as a result of the enactment in late December of the “Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010″. The new law provides a $5million gift tax “exemption” for taxpayers. This means that a married couple can freeze up to $10million in assets without paying any gift tax. In addition, the currently depressed values of many assets (e.g., real estate, bank stocks) enhance the potential benefit of this strategy (because they are likely to appreciate).
COMMON METHODS. Examples of common estate freeze techniques are:
Outright Gift: An outright gift is the simplest and least desirable method of implementing of an estate freeze: the transferor loses all property interests in the transferred asset. If properly structured, any post-transfer appreciation will be excluded from federal estate taxation.
Gifts In Trust: In general, these produce the same result as an outright gift where the transferor is not also a beneficiary of the trust (but see “Solution”, below).
Sale Of Appreciating Assets: The sale (usually to a family member or to a trust) of assets which are likely to appreciate in exchange for a promissory note (issued at the date of sale for fair market value) will also effect an estate freeze, because the value of the promissory note held by the transferor (seller) will usually be subject to federal estate tax at a value equal to its unpaid balance (although “self-cancelling” notes “disappear” at death). However, the transferor will again lose all property interests in and any potential benefits from the asset(s) sold (but see “Solution”, below).
Impediments: A major impediment to the implementation of a typical estate freeze used to be that it might have constituted a taxable gift, although, with the new $5million exemption this is less likely. The even more important impediment is that the typical estate freeze will result in a loss by the transferor of all interests in the property given away. People want to “have their cake and eat it too”; that is, they want to retain some type of interest in the transferred property and obtain the estate tax benefit. In the usual case, if they retain any type of interest in the transferred property, the transfer will not be complete for federal transfer tax purposes, thereby not effecting an estate freeze (see below).
TECHNICAL NECESSITIES. A little technical background is necessary here. In order to effect an estate freeze, we need a “completed transfer” for federal estate & gift tax purposes. Under the trust law in most jurisdictions, property transferred to a trust in which the transferor is also a beneficiary (remember “have your cake and eat it too”?) can be reached by the transferor’s creditors to the extent the transferor could possibly receive benefits from the trust. The IRS says, because of that, the transfer is incomplete for estate & gift tax purposes. Thus, in the usual case, a trust of which the transferor is a beneficiary will be included in the transferor’s estate for federal estate tax purposes (no freeze).
SOLUTION. Ok, we want to have an interest in the transferred property AND obtain an estate tax benefit. How can we accomplish that? The IRS, in several well-reasoned public and private rulings, has held that if a transferor establishes his/her trust in a jurisdiction whose laws will not permit the transferor’s creditors to reach trust assets (as they would be able to in most places as a result of the transferor being a discretionary beneficiary of the trust), that the transfer will be complete, and will be excluded from the transferor’s estate for estate tax purposes.
WHY OFFSHORE? Although the laws of a few states allegedly restrict a creditor’s access to trusts under the circumstances described above, there are numerous uncertainties in that regard (See, APN, Vol. VII, No. 1). However, we know that certain offshore jurisdictions will be effective to that end. To summarize: You can set up a trust in certain jurisdictions and be a discretionary beneficiary of your trust, and it will be excluded from estate taxation in your estate. Do your assets have to be offshore? The answer is: NO. Can they stay at your favorite broker? YES.
Note that we have not mentioned anything about U.S. income tax. That’s because, even though the trust described above will not be subject to U.S. estate tax in the transferor’s estate, it will still be a “grantor trust” for U.S. income tax purposes, requiring the transferor to report all trust income personally (See, APN, Vol. VI, No. 4 for a discussion of these tax laws).
Variations of the technique discussed in this issue can be effectively implemented for nonresident aliens owning U.S. real estate or for those wishing to immigrate into the United States. Properly implemented, such planning can result in the elimination of our estate tax for such persons.
CONCLUSION & CAVEAT: The structure discussed in this issue will only be effective if certain rules are strictly followed in the planning and operation of the trust (beyond the scope of this issue).