Tax Law

Estate Planning Update

We are into the second quarter of 2010 and still no federal estate tax. Will Congress pass new legislation? And if so, will it be retroactive? Congress has given no indication it will do anything, so we are likely to be dealing with this uncertainty for most of 2010. The possibility also is increasing that the arrival of 2011 may bring with it the return of a federal estate tax with a $1 million exemption and a 55 percent maximum tax rate. As we noted in our December 2009 Estate Planning Update (http://www.pepperlaw.com/publications_update.aspx?ArticleKey=1672), this may be a good time to review your estate plan to ensure that neither too much nor too little will pass to your intended beneficiaries.

Meanwhile, executors and beneficiaries of estates of decedents dying in 2010 are coping with "carry-over" basis, the need to determine the decedent's basis in estate assets (do you know what you paid for everything you own?) and how to allocate the $1.3 million basis increase among heirs (there is an additional $3 million increase for assets passing to or for the benefit of a surviving spouse).

These are difficult times to plan, but plan you must, or your heirs may find themselves in very difficult and uncharted waters.

Still Some Good News But It May Be Fleeting

As we discussed in our April 2008 Estate Planning Update (http://www.pepperlaw.com/publications_update.aspx?ArticleKey=1146), current depressed asset values combined with historically low interest rates offer many opportunities to transfer wealth efficiently.

One of those opportunities is the use of a grantor retained annuity trust (GRAT). A GRAT captures a portion of an asset's appreciation and removes it from the donor's estate, allowing it to pass to the next generation free of estate and gift taxes. Essentially, a GRAT pays the donor an annuity for a set number of years (known as the annuity period) based on an interest rate set monthly by the IRS. If the assets held in the GRAT appreciate at a rate in excess of the IRS interest rate at the time the GRAT is established, that appreciation will pass to the next generation without gift or estate tax. The lower the IRS interest rate, the lower the annuity payments will be and the greater the portion of the appreciation that can be captured.

A downside to creating a GRAT is that if the grantor does not survive the annuity period, the value of the property in the GRAT will be included in the grantor's taxable estate. Accordingly, GRATs often are created with short annuity periods (such as two to five years) to increase the chance of surviving the annuity period.

The benefit presently offered by these short-term GRATs may be fleeting. On March 24, 2010, the House of Representatives approved H.R. 4849, the "Small Business and Infrastructure Jobs Tax Act of 2010." The bill, which is now in the Senate, includes a provision that has a direct impact on GRATs by requiring that all GRATs must have a minimum annuity period of 10 years. Obviously, this provision increases the risk that the grantor will die during the annuity period and limits the attractiveness of a GRAT. As the legislation is currently drafted, this new GRAT limitation will apply to transactions entered into after the effective date of the new law, i.e., the date an act is signed by the President; however, the effective date may change in the Senate version or in any compromise legislation produced by a House-Senate conference committee. H.R. 436 also is pending in the House; if enacted, it would eliminate valuation discounts in connection with certain transfers of property (discussed in our April 2009 Estate Planning Update, http://www.pepperlaw.com/publications_update.aspx?ArticleKey=1465).

This pending legislation, combined with the present low interest rates and low asset valuation environment, make now an attractive time to consider a GRAT as well as other wealth transfer techniques.

Demutualized Stock May Have a Basis

Individuals and trusts that own life insurance policies issued by a mutual insurance company own an interest in the company itself in addition to a life insurance policy. When that company "demutualizes," policy owners receive shares of stock representing the value of the ownership interest in the company. The IRS has always taken the position that the recipient's basis in the stock is zero, meaning that when the stock is sold, the entire proceeds of sale had to be recognized as gain. However, in early 2009, the Federal Court of Claims held that the stock basis was not zero and, instead, that the stock had value when issued such that some basis had to be allocated to it. That decision was recently upheld by the Court of Appeals for the Federal Circuit.

What does this mean? While the IRS has not indicated that it will acquiesce in the conclusion of these courts, when you sell stock received as part of a demutualization of an insurance company, you may wish to consult with your tax counsel about treating the value of the stock assigned by the insurance company when distributed as your basis in computing any capital gain. If you have filed a return reporting the entire proceeds of sale as gain and the return is still open, you may wish to consider filing an amended return claiming a refund.

The material in this publication is based on laws, court decisions, administrative rulings, and congressional materials, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship. Internal Revenue Service rules require that we advise you that the tax advice, if any, contained in this publication was not intended or written to be used by you, and cannot be used by you, for the purposes of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

This article is republished with permission of Pepper Hamilton, LLP. Further duplication without the permission of Pepper Hamilton, LLP is prohibited. All rights reserved.