Increased Gift Tax Annual Exclusion
Under the federal gift tax laws, during any calendar year, each individual can make gifts that qualify for the "annual exclusion" without any gift tax consequences. For a number of years, the annual exclusion for gifts to each individual donee has been $11,000 per donee, or $22,000 for gifts made by a husband and wife. Effective January 1, 2006, the gift tax annual exclusion will increase from $11,000 to $12,000 per donee, or $24,000 for married couples. You should remember, however, that this change will not apply until 2006, so you should not increase your annual exclusion gifts for 2005.
A reminder to those who make annual gifts into trust for their families, including premium payments for insurance policies held in an insurance trust: it is important to execute so-called "Crummey" withdrawal notices each year to attempt to qualify these gifts for the annual exclusion. The reason is that gifts qualify for the annual exclusion only if they are gifts of "present interests" in the transferred property. For example, an outright gift of cash would clearly qualify as a gift of a present interest, in contrast to a gift in trust that typically postpones the unfettered beneficial enjoyment of the gift until some future point in time. Therefore, in order to qualify a gift in trust for the annual exclusion, it is necessary to give the beneficiary the right to withdraw such gift from the trust for a limited period of time, a procedure that was approved in a case called Crummey v. Commissioner. Once the withdrawal period expires, the beneficiary no longer has the right to withdraw such gift.
Although the IRS has reluctantly agreed that a withdrawal right over a gift in trust will transform that gift into a present interest qualifying for the gift tax annual exclusion, it has steadfastly ruled that the beneficiary must have "actual notice" of his or her withdrawal right. There are recent indications that the IRS is becoming more diligent in asking for proof that such notice has been provided in gift and estate tax audits. In cases where the taxpayer has been unable to prove that notice was given, the IRS has disqualified the gifts in question for the annual exclusion, resulting in increased tax liability.
Notice does not necessarily have to be in written form, but written notice is obviously the best form of evidence if the IRS asks for proof that notice has been given. Hence, we have always recommended that each year when you are making annual exclusion gifts into trust, you should provide the beneficiaries with a signed written notice of the beneficiaries' rights to withdraw such gifts, and the beneficiaries should sign and return this notice as an acknowledgment of their rights.
If you are making annual exclusion gifts into a trust but have not been executing written withdrawal notices of these gifts to the trust beneficiaries each year, we suggest that you contact an attorney who can help you prepare such notices for all your future annual exclusion gifts.
Recent "Family" Limited Partnership Rulings Favor Taxpayers
Over the past decade, limited partnerships have been used by families increasingly to consolidate assets, provide for creditor protection and involve members of the younger generation in financial decision-making (hence the name "family" limited partnership). The IRS has continuously challenged valuation discounts claimed on gift and estate tax returns with regard to limited partnership interests in "family" limited partnerships. After a number of cases in which the taxpayer "lost" (valuation discounts were rejected or significantly reduced), there have been a number of cases recently in which valuation discounts have been upheld. The cases where the discounts were rejected generally involve bad facts (e.g., where the integrity of the partnership as a separate entity was not respected and the partnership was treated as the taxpayer's personal bank account). The cases where discounts have been upheld involve situations where there is a legitimate purpose for the partnership and the partnership is treated as a separate entity. While this area of the law continues to be contested between taxpayers and the IRS, these recent decisions suggest that there may continue to be significant benefits to a family forming a limited partnership.
Connecticut Enacts New Estate And Gift Tax
Connecticut has enacted a new gift and estate tax regime applicable to estates of decedents dying and gifts made after 2004.
There is no tax to the extent that gifts and transfers at death do not exceed $2 million in value, in the aggregate. However, there is no exemption if the value of gifts and transfers at death exceed $2 million. Hence, once the $2 million threshold is exceeded, even by $1, the tax applies on that $2 million of gifts or transfers at death, as well as to amounts of more than $2 million.
The tax rates start at 5.085% and reach 16% for gifts and transfers in excess of $10 million.
Taxable gifts do not include gifts that are excludable for federal tax purposes (i.e., annual exclusion gifts, tuition payments and certain medical payments).
In the case of a Connecticut resident, assets transferred by gift and at death are subject to Connecticut's gift and estate tax; however, gifts of real estate or tangible personal property (e.g., art work) located outside Connecticut are not subject to gift tax.
In the case of estate tax, the new law purports to tax real estate and tangible personal property located outside Connecticut, although a credit for estate tax paid to the other state is provided for.
In the case of a nonresident of Connecticut, real estate and tangible personal property located in Connecticut transferred by gift and at death are subject to tax. In the case of the estate tax, Connecticut provides a credit for estate tax paid to another state.
Connecticut follows the federal gift and estate tax system in allowing an unlimited deduction for transfers to a spouse or charity by gift or at death.
All estates of Connecticut residents and estates of nonresidents of Connecticut who have property in Connecticut must file an estate tax return regardless of the amount of assets involved.
As with any significant new tax legislation, planning opportunities as well as planning pitfalls are presented by the Connecticut law.
Since a taxable estate of up to $2 million is fully exempt from estate tax, but a taxable estate of more than $2 million is fully taxable, to the extent possible, planning to reduce the taxable estate to $2 million or less is called for. Such tax savings may amount to $101,700 (5.085% x $2 million) or more. This can be accomplished by gifting assets during lifetime (e.g., to family members) and/or transferring assets at death to charity.
The law treats lifetime gifts by a Connecticut resident of out-of-state property more favorably than transfers of such property upon the death of a Connecticut resident. Such property may be transferred by gift free of Connecticut gift tax, whereas such property transferred at death may be subject to Connecticut estate tax. Connecticut residents may wish to consider making gifts of out-of-state property, especially if the state in which such property is located does not impose a gift tax and no federal gift tax will be imposed.
For nonresidents of Connecticut, because Connecticut imposes an estate tax on 100% of the value of real estate and tangible personal property located in Connecticut in excess of $2 million, planning is necessary to gift these assets (e.g., to family members) before the value exceeds $2 million and/or to convert these type assets to intangible property by transferring them to a limited liability company or other entity.
The Connecticut estate tax provides for the making of a special election that can be used to make an otherwise eligible trust qualify for a marital deduction for Connecticut (but not federal) estate tax purposes. This election, which is not available for gift tax purposes, will be of use at such time as the federal estate tax exemption exceeds the $2 million Connecticut exclusion amount (currently scheduled to occur in 2009). The election may make it possible for estates to utilize the full federal exemption (scheduled to reach $3.5 million as of 2009) and qualify the difference between the $2 million Connecticut exemption and the federal exemption for the Connecticut marital deduction thereby avoiding Connecticut estate tax on such difference at the death of the first spouse.
Estate tax apportionment provisions of existing estate plans will have to be reviewed and analyzed to make sure that the estate tax burden is properly allocated. This is particularly true in light of the fact that a $2 million taxable estate will pay no tax in Connecticut whereas a taxable estate of $2,000,001 will pay tax on the full amount ($101,700).
Connecticut estate tax can be avoided by an estate of any size if the decedent makes $2 million of gifts and arranges for the balance of his or her property to pass to or for the benefit of a spouse and/or charity in a manner qualifying for the marital or charitable deduction. Another approach is for a Connecticut resident to leave the $2 million Connecticut exemption amount to children (or in some other manner that will not be eligible for the marital or charitable deduction) and the rest of the estate in a marital deduction qualifying disposition. In the latter case, the special Connecticut marital deduction election could be used to avoid loss of a portion of the federal estate tax exemption once that exemption exceeds the amount of the Connecticut exemption.
Proposed Treasury Regulations Regarding Nonqualified Deferred Compensation Plans
Proposed Treasury Regulations under Section 409A of the Code were released on September 29, 2005. While proposed to become effective January 1, 2007, taxpayers may rely on them in the interim. The proposed regulations require (1) that arrangements providing "nonqualified deferred compensation" be fixed by December 31, 2006, to the extent necessary so as to comply with the various rules that now apply to nonqualified deferred compensation plans, and (2) that such arrangements be operated in the interim in compliance with the new rules. Failure to comply will result in taxation of participants before cash or property is received, and imposition of what is, in effect, a penalty tax rate 20% above the participant's regular tax bracket.
Listed below are types of arrangements that may be considered to provide nonqualified deferred compensation benefits that should be reviewed for compliance with the new Code Section 409A Regulations and possible modification:
"Top-hat" executive retirement plans (sometimes referred to as "supplemental executive retirement plans" or SERPs).
Executive deferral plans (sometimes mirroring a 401(k) plan but permitting larger deferrals than are permitted in a "qualified plan" such as a 401(k)).
Employment agreements that provide for payments on death, disability or termination of employment.
Severance benefit plans (particularly problematic are plans for top executives of public companies and severance plans of a public company that are triggered upon the occurrence of a "change of control" of the company).
Equity-based compensation plans. Stock options can be considered a form of nonqualified deferred compensation, particularly if the option is granted at less than fair market value of the underlying stock determined as of the date of grant. Phantom stock plans, "restricted stock units" (as distinct from normal "restricted stock" grants), stock appreciation rights and other phantom equity arrangements can all be considered to be forms of nonqualified deferred compensation plans.
Split-dollar arrangements that involve payments from the employer to the key employee at a future date or a future transfer of property (e.g., as where a life insurance policy is to be "rolled out" to the employee at some future date or where other future payments of "compensation" may be made to an employee to continue an existing split-dollar arrangement) may be considered to be a form of nonqualified deferred compensation.
Current Status Of Federal Estate Tax Reform Or Repeal
As reported in our December 2004 Private Client Services Alert, the movement to reform or repeal the federal estate tax was reinvigorated by President Bush's election to a second term and the increased Republican majority in Congress. At the beginning of 2005, it appeared that significant reform, if not outright repeal, of the federal estate tax was a legitimate possibility before year end. However, debate in Congress over estate tax reform came to a grinding halt this fall in light of budgetary concerns and the political fallout from Hurricane Katrina. After returning from summer recess, the Senate cancelled a scheduled vote on a bill that would have repealed the estate tax. Since the cancellation of that vote, no action has been taken in Congress on estate tax reform. Most estate planning experts and political observers continue to believe that significant reform is more likely than outright repeal and that reform will happen before 2010 (the year in which current law provides that the estate tax will be repealed only to be reinstated in 2011). We will continue to keep you updated on any developments concerning reform of the federal estate tax.
Steven G. Winters is a Partner in the Firm's Private Client Services Group. He concentrates his practice in the areas of estate planning, estate administration and probate law, taxation, and general business representation of individuals and closely held companies.