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PLANNING NOTE: Less than 2 percent of term life insurance policies ever pay off on the death of the insured. The policies are generally cancelled long before death. So if you plan to establish an irrevocable life insurance trust (ILIT) in 2012 (e.g., to take advantage of the large gift tax exemption and transfer a large amount of cash to the trust in order to avoid future Crummey powers), evaluate whether or not GST exemption should be allocated. If you knew for certain that the exemption would drop to $1 million in 2013 and not increase again in the future, it might make sense to use up GST exemption regardless of the likelihood of benefit: If you don’t use it, you will lose it. On the other hand, allocating what remains of your GST exemption to an inefficient trust, like an insurance trust holding term insurance, would be a waste of a valuable exemption if the law is not so harshly changed in 2013.
A better approach might just be to design a better trust in 2012 and instead of using a rather plain vanilla ILIT, use a DAPT-ILIT combination. The domestic asset protection trust (DAPT) is explained in more detail in Chapter 5. A key feature of a DAPT is that you may be a discretionary beneficiary of the trust. The concept of an ILIT that holds insurance on your life can be combined with a DAPT to which completed gifts are made, so in effect you are a beneficiary of a trust that owns life insurance on your life. This might avoid the need to have multiple trusts. You can use assets transferred to the DAPT to pay insurance premiums. When a DAPT structure is used in this manner, GST exemption would likely be allocated to the trust. There are obviously technical complications to creating and maintaining such a trust so refer to Chapter 5.
GST Automatic Allocation Rules
The mechanism by which GST exemption is allocated to a trust is complex and you should be careful in how you address GST allocations on federal gift tax returns (Form 709) for the 2012 year, especially with consideration to the automatic allocation rules.
In very simple terms, if assets are given to a trust that could benefit your grandchildren or more remote descendants (skip-persons), distributions to them from that trust would be subject to GST tax. To minimize the number of taxpayers to which the GST tax applies, each taxpayer is afforded an exemption from the GST tax. The 2010 Act increased this GST exemption to $5 million inflation adjusted, which is $5.12 million in 2012. If a proper amount of the donor’s GST exemption is allocated to the gift to the trust (i.e., the trust has an inclusion ratio of zero), the trust can be made entirely exempt from the GST tax. If $5.12 million was given to the trust (and assuming no other gifts are ever made to the trust), and $5.12 million of GST exemption was allocated to protect that gift, then the trust would be exempt from GST tax for as long as it lasts. No matter how large the trust may grow in value, and no matter to whom distributions are eventually made, and no matter for how long assets grow inside the trust, no GST tax will apply. The GST tax rules automatically allocate your GST exemption in certain instances in order to assist taxpayers in avoiding running afoul of the complex GST allocation rules.
Unfortunately, the automatic allocation rules don’t always work as intended and can result in a waste of your GST exemption. Moreover, unless the law is changed, the automatic allocation rule ends this year and, most important for some, it is possible that the automatic allocation rules will be treated as if they were never enacted. If this occurs, then after this year, the trust would no longer be exempt from GST tax. In effect, allocations made automatically to a trust in years before 2013 would be treated as if they were never made. This could upset the planning for many existing trusts. While most estate planners anticipate that these rules will be continued to avoid this problem, as with so many tax issues, there is simply no guarantee.
PLANNING NOTE: Be aware that 2012 may present a different planning paradigm. If the GST exemption declines from $5.12 million to an inflation-adjusted $1 million in 2013, allocating a disappearing GST exemption in a less than optimal manner may be far preferable than not allocating exemption dollars that may simply disappear. When making GST allocation decisions on 2012 gift tax returns, absent any certainty in the law at that time, you should be cautious to weigh these issues. Prudent planning may require extending 2012 gift tax return filing dates as long as possible in the hope that the new law will become known during that period. (However, we may end up with another two-year bandaid like Congress put on the estate tax system in 2010.)
PORTABILITY OF UNUSED EXEMPTION DOES NOT NEGATE NEED FOR PLANNING
Portability was a concept introduced by the 2010 Act—essentially, it permits a surviving spouse to “inherit” the unused remaining estate tax exemption of the spouse who died first. More specifically, portability provides that, if one spouse dies and certain requirements are met, the surviving spouse can qualify to use the entirety of the unused $5.12 million exemption amount of the deceased spouse. The impact of this was that without any complex wills or trust planning, the more “average” wealthy family could still take advantage of both spouses’ exemption amount. Most tax experts generally recommend not relying on portability for a host of reasons, including:
•It is scheduled to sunset (expire) at the end of 2012. While President Obama has suggested it be made permanent, there is no assurance it will.
•It is not available for GST tax planning purposes—that is, the GST exemption of the spouse dying first is not portable. With proposals to limit GST planning, it is even more imperative that appropriate GST exemption planning be done.
•Portability affords no estate tax protection for the appreciation in assets bequeathed outright to the surviving spouse. In contrast, if the assets were left to a bypass trust outside the surviving spouse’s estate (that is, a trust that bypasses the estate of the surviving spouse for estate tax purposes), the entire trust, including all post-death appreciation, would remain outside the surviving spouse’s taxable estate.
•There is no creditor protection with portability if the estate of the spouse dying first is left outright to the surviving spouse. However, some protection could be afforded if the assets are instead left to a marital trust (qualified terminal interest property trust, QTIP) on the first spouse’s death.
•The surviving spouse, absent the bequest of assets to a trust, such as QTIP, or the use of a will contract, could dispose of the inherited assets to a new spouse.
The real risk of portability in 2012 is that the false or misplaced reliance on portability will keep some taxpayers away from the planning table. Even if you view yourself as a smaller wealth taxpayer, reliance on portability in lieu of appropriate 2012 planning could be a costly mistake. The points just mentioned, while only some of the issues, should suffice to demonstrate this.
UNIFICATION
The exemption for gift, estate, and GST purposes is $5.12 million. That is, the exemption amount is unified for all three transfer taxes. It was not always so, and it may not always stay so.
Prior to the 2001 Act (EGTRRA), the estate and gift taxes were unified (that is, the rates were the same), creating a single graduated rate schedule for both the gift and the estate tax. That single lifetime exemption could be used for lifetime (or inter-vivos) gifts and/or testamentary bequests. EGTRRA decoupled these taxes, fixing the gift exemption at $1 million while the estate and GST exemption amounts increased. The 2010 Act reunified all three transfer taxes with a $5 million exemption that
