TRAPS AND CONCERNS IN USING INTENTIONALLY …

1 TRAPS AND CONCERNS IN USING INTENTIONALLY defective GRANTOR TRUSTS JOHN P. DEDON AND DANIEL E. INGERSOLL The estate law uncertainty created by a dysfunc tional Congress and political posturing has re sulted in a planning environment of confusion and extremes, ranging from no estate tax, to gen erous gift and estate exemptions, to the re-imposi tion of only a $1 million gift and estate exemption amount with a 55% tax rate. This article discusses a common strategy that remains viable during 2012- USING an in tentionally defective grantor trust ( idgt ) to achieve estate tax advantages. Indeed, as preva lent as IDGTs have been this past decade for asset transfers, they should be even more pop ular this year because 2012 may be the last year all the idgt advantages exist.

2 However, this article's primary focus is not the transfer tax ad vantages of USING an idgt -those advantages are well known and Rather, this article considers common pitfalls associated with USING IDGTs that may be overlooked, many of which are income tax related. Consider these case studies: 1. Harry and Wiley, husband and wife, have $10 million in marketable securities. Harry creates an idgt for Wiley, naming her as trustee and a JOHN P DEDON, , is a principal and DANIEL E. INGERSOLL, , is an associate at Odin, Feldman & Pittleman PC in Fairfax, Virginia. beneficiary along with the children. Wiley cre ates an idgt for Harry, naming him as trustee and a beneficiary along with the children.

3 They each transfer $5 million of marketable securi ties into the other's trust. Assuming each trust does not give Harry or Wiley a general power of appointment,2 Harry and Wiley can be both the trustee and a beneficiary with their children. Thus, as long as Harry and Wiley are married and living, they can continue to benefit from the trust income and assets, yet take advantage of the $5 million exemption amount while it ex ists, thereby sheltering $10 million from estate tax. Or can they? 2. Harry also owns Harry's Security Company (the Company), a. $40 million business that provides consulting services and hardware.

4 Harry's estate lawyer has recommended con verting from a C corporation to an S corpora tion to facilitate a stock transfer USING an idgt . Harry knows the stock can be discounted for gift tax purposes, particularly if a class of non voting stock is created. However, his account ant has raised several income tax issues, in cluding the effect of nonvoting stock on the S corporation status, eligible S corporation shareholder issues, and the imposition of the built-in gains (BIG) tax. Do these income tax issues trump the estate tax advantages? AUGUST2012 PRACTICAL TAX STRATEGIES Practitioners and clients who hasten complete transfers to INTENTIONALLY defective grantor trusts before some of the advantages disappear in 2013mustbe careful to avoid planning TRAPS .

5 71 72 3. Harry knows that limited liability companies (LLCs) are useful planning tools because they provide asset protection and because nonvot ing LLC interests can be transferred to enhance market and minority discounts, similar to transferring nonvoting stock in a corporation. Thus, Harry can transfer as much as 99% of the LLC equity but yet retain 100% control. In fact, the office building the Company rents is held in HW LLC, which is owned 50% each by Harry and Wiley. Because of these LLC ad van tages, Harry is considering transferring his Company stock to HW LLC, or creating a sep arate LLC to own the Company stock.

6 Harry's thought is that, if he transferred all of his Com pany stock to an LLC, he could then transfer a nonvoting assignee interest in the LLC to his idgt and thereby avoid having to create non voting Company stock. However, once again Harry's accountant has raised a number of is sues pertaining to the LLC and the idgt , in eluding whether HW LLC, can own S Corpo ration stock, and whether Harry and Wiley can transfer their HW LLC, 50% interests to one idgt . He mentions there may also be FICA taxes added to the tax cost of USING an LLC. After a brief introduction to the current es-tate and gift tax state of affairs and a review of idgt mechanics, this article will address the planning pitfalls pertaining to the fact scenar ios above.

7 2012-The end of the world as we know it In the estate world, the dominant theme in 2011 was the extraordinary asset transfer opportunities available to the wealthy. One could give $5 million ($10 million for a married couple) to children or Akers, Blattmachr, and Boyle, "Creating Intentional Grantor Trusts," 44 Real Prop. Tr and Est 207 (Summer 2009), Oshims and Joshins, "Protecting and Preserving Wealth Into the Next Millennium," 137 Trusts. & Estates. 68 (October 1998); Mulligan, "Sale to an INTENTIONALLY defective Irrevoca ble Trust for a Balloon Note-An End Run Around Chapter 14 ?" 32 U. of Miami Philip E.

8 Heckerling In st. on Est. Plan. Ch. 15 (1998); Oshins, King, and McDowell, "Sale to a De fective Trust: A Life Insurance Technique," 137 Trusts & Es tates 35 (April 1998). Section 2041 (b)(1) generally defines a general power of ap pointment as "a power which is exercisable in favor of the decedent [Harry or Wiley in this example], his estate, his creditors, or the creditors of his estate." However, according to Section 2041 (b)(1 )(A), a power to consume, invade or ap propriate trust income, corpus or both for the decedent's benefit is not deemed a general power of appointment if it's "limited by an ascertainable standard relating to the health, education, support or maintenance of the decedent.

9 " Also targeted for elimination are other advantageous trans fer strategies, such as two-year GRATs, which are outside the scope of this article. PRACTICAL TAX STRATEGIES AUGUST 2012 other beneficiaries in a "dynasty trust" ( , a trust lasting in perpetuity) and thereby protect those assets from estate tax and creditors. The dynasty trust was often created as an idgt as described below. The assets also could be discounted to 60% or 70% of their value for transfer tax purposes. The gifts could be leveraged to allow for even greater asset transfers, through techniques that benefit from low interest rates. In short, the stagnant economy, low interest rates, and advantageous gift and estate tax laws, combined to make 2011 a banner year for wealthy taxpayers doing estate planning.

10 Will this optimal estate planning environment con tinue in 20 12? Financial experts expect the stagnant economy and low interests rates to continue. Also in place is the $5 million exemp tion, which was increased by $120,000 for a cost ofliving adjustment. The Obama adminis tration and Congress have targeted discounts on intra-family transfers and limiting dynasty trusts to 90 years,3 but both advantages cur rently remain. It is likely that the $5,120,000 exemption will remain until 2013, when the exemption amount falls to $1 million. Hopefully, dis counts and unlimited dynasty trusts will re main too. Thus, those who wanted to act in 2011 but failed to do so still have the opportu nity to transfer significant assets estate and gift tax-free during Why transfer assets to an idgt Lifetime gifts of assets, such as closely held stock, real estate, or marketable securities, from parents to children shift such assets to the next generation while minimizing estate taxes.