Estate Planning Update
Publisher: Day Pitney Newsletter
12/22/2008

Gift Tax Limits Increased for 2009
Several key transfer tax amounts are inflation-indexed and therefore are subject to change each year. For 2009, the "annual exclusion" from federal gift tax has been increased to $13,000, which means that gifts to individuals of up to $13,000 during 2009 are not required to be reported. Also, the "annual exclusion" for gifts to a non-citizen spouse has been increased to $133,000. (Gifts to a non-citizen spouse do not qualify for the unlimited marital deduction but instead have a larger annual exclusion.)

Federal Estate Tax Exemption Increased
Changes to the tax laws in 2009 include a welcome increase in the federal estate tax exemption. Starting January 1, 2009, the amount excluded from federal estate tax will jump from $2,000,000 to $3,500,000. Taking full advantage of the increased federal exemption on the death of a married individual living in a state with a state estate tax, however, could come with an unexpected state estate tax cost. This is a result of marked differences between the applicable federal and state tax exemptions.

Here are the applicable state exemptions for the following states:

State ----- Exemption
Connecticut - $2,000,000
Massachusetts - $1,000,000
New Jersey - $675,000
New York - $1,000,000

The increase in the federal estate tax exemption means that Connecticut residents in 2009 will be subject to a federal estate exemption that is higher than the applicable state estate tax exemption, joining residents of many other states, including New York, Massachusetts and New Jersey. Although the higher exemption may result in lower federal estate taxes on the death of the surviving spouse, it can also cause unanticipated state estate tax to be due at the death of the first spouse, when previously no tax would have been due, if your estate plan has not been updated to account for the possibility of differing federal and state estate tax exemptions. For residents of these jurisdictions, if the estate plan is designed to minimize federal estate taxes only, there may be state estate tax of as much as $229,200 at the death of the first spouse.

It is more important than ever for residents of a state with a state estate tax to find out whether your estate planning documents should be updated in light of the possibility that the federal and applicable state estate tax exemptions are different at the time of the death of the first spouse. For a resident of such a state (or a resident of any state who owns real property in such a state) with a traditional estate plan designed to avoid estate tax at the death of the first spouse by maximizing use of the federal estate tax exemption, there will be no federal tax due at the death of the first spouse, but there could be state tax due. For example, a New York resident dying in 2009 with a taxable estate of $3,500,000 (net of all deductions, including the marital and charitable deductions) would owe $229,200 in New York state tax at his death. In many, but not all, cases, it will make sense in the long run to pay the relatively small amount of state tax at the first death to avoid paying substantially more federal tax at the second death. If our New York resident's wife died later in 2009 with her own taxable estate of $3,500,000, she would have saved over $900,000 in federal taxes in her estate by paying $229,200 in her husband's estate. Especially in light of the continuing uncertainty about the future of the federal estate tax, you may wish to consider an estate plan that contains the flexibility to react to the federal and state tax laws in effect at the time of your death, instead of trying to predict those laws at the time you sign your documents.

Connecticut and Massachusetts residents or property owners should also be sure that their plans take advantage of the provision of those states' estate tax laws that permits an estate both to make full use of the federal exemption and avoid state estate tax at the first death.

Now that a new president has been elected, we expect that Congress will make changes to the federal estate tax laws in the next year or so. Various proposals have been made over the last few years, and it is not clear at this early date which of them will eventually be enacted. In all likelihood, however, a federal estate tax will continue to be a reality for some time to come, and estate tax planning will continue to be important for many of our clients. If you have not reviewed your estate planning documents in the last few years (and certainly since 2001, when the last major change to the federal estate tax laws was made), we strongly urge you to contact us for a review of your planning.

Direct Charitable Rollovers Extended for Calendar Years 2008 and 2009
Another welcome change to the tax laws is an extension of the opportunity for direct charitable rollovers from IRAs in certain circumstances through the end of 2009. The $700 billion Emergency Economic Stabilization Act of 2008 passed by Congress and signed into law by President Bush last October extended a popular tax break that allows individual taxpayers who are at least 70½ to exclude up to $100,000 annually of otherwise taxable IRA distributions that are paid directly to qualifying charitable organizations. The extension is effective for calendar years 2008 and 2009.

Tax Advantages of Exclusion
Before this special exclusion first became available in 2006, the use of IRA assets to make a lifetime gift to charity required that you withdraw funds from your IRA account as taxable income and then take a charitable income tax deduction for the gift. As a result of complexities arising from charitable deduction ceiling limitations and phase-outs for itemized deductions and personal exemptions, the result was seldom a complete wash. Treating the direct distribution of IRA funds to charity as a pure exclusion from income has many important tax advantages which make such charitable giving attractive.

  • Gifts to charity from an IRA account are not subjected to the maximum ceiling and carry forward limitations that would otherwise apply. Thus, if you have already maximized the charitable income tax deduction for the year, you still can take full advantage of the exclusion for gifts made directly from an IRA over and above any charitable income tax deduction to which you may be otherwise entitled.
  • Since the withdrawn amount is not included in federal taxable income, it does not (i) affect the phase-out of itemized deductions and the phase-out of the alternative minimum tax exemption, (ii) increase the floor thresholds for the deductibility of medical expenses and miscellaneous itemized deductions, or (iii) increase the level of taxability of social security income.
  • Treatment as an exclusion means that if you do not itemize deductions for federal income tax purposes you still can enjoy the equivalent of a full charitable income tax deduction.
  • Similarly, taxpayers in states such as Connecticut and Massachusetts that tax IRA distributions but do not allow the benefit of itemized deductions also receive the benefit of their contributions for state income tax purposes.
  • The distribution to charity can be applied in satisfaction of your minimum required distribution for the year, thus reducing the level of taxable income that otherwise would be recognized. Additionally, the distribution will be characterized as a withdrawal distribution from the taxable portion of the IRA account if you made after-tax contributions in the past, thus preserving the availability of such after-tax contributions to minimize the taxability of future withdrawals.

Which Taxpayers Qualify?
The exclusion applies to individuals who have attained age 70½ by the date of contribution. The maximum amount that can be excluded is $100,000 per individual per year, which means that a married couple could donate up to $200,000, assuming each spouse has an IRA with at least $100,000 in before-tax contributions and earnings.

Which Charities Qualify?
In general, the gift must be made to a so-called public charity such as a church, hospital, school, museum, etc. Gifts to donor-advised funds, supporting organizations and most private foundations do not qualify. Taxpayers can make as many gifts in any amounts they choose as long as the $100,000 per taxpayer limitation is not exceeded within a single calendar year.

Which IRA Accounts Qualify?
Traditional and inherited IRA accounts, as well as Roth IRA accounts, qualify for the exclusion. Simple IRA accounts and SEP IRA accounts can qualify if the taxpayer did not make contributions to the IRA plan within the same qualified plan year as the year in which the charitable distribution takes place. Only distributions that otherwise would have been taxable distributions qualify.

How To Arrange For The Distribution
Forms should be available from your IRA custodian. It is important that the distribution be made by the IRA custodian directly to charity -- although the tax rules do permit the IRA custodian to provide you with a check made payable to the designated charity, which you can then deliver or mail to the designated charity with your own personal letter. A check made out to you that you subsequently endorse over to the recipient charity, however, will not qualify for the exclusion. Also, it is critical under the tax rules that the gift be acknowledged in writing by the charitable organization in order to qualify for the exclusion.

Intrafamily Loans
Recent events in the financial markets have created a much discussed "credit crunch" in commercial lending institutions. With interest rates from commercial lending institutions still significantly below historic averages, it is natural to be focused on the opportunities of low-cost borrowing. However, it may be difficult in this economic climate to find commercial lending institutions willing to lend money to assist your family with its needs. For example, you may have a child or grandchild looking to purchase a home, fund home improvements, start a business, or provide liquidity for investments or any number of other purposes.

While commercial rates are certainly low, they are not the only rates that are at historical lows. IRS published rates are also at their lowest level in some time, and these low rates present real planning opportunities to allow you to assist your family while, at the same time, shifting wealth between generations with little or no gift tax implications.

Intrafamily loans present one such planning opportunity. Intrafamily loans may be made without gift tax implications as long as the lender charges interest at a rate no less than the "applicable federal rate." The applicable federal rates are determined and published by the IRS on a monthly basis and are based on the average market yield on outstanding marketable US government obligations of varying lengths.

With proper planning, an intrafamily loan can provide a significant benefit to a junior generation family member with relatively modest tax implications to the senior generation family member. Not only can intrafamily loans be made at rates lower than those commercially available, but the payment terms can be designed to fit the specific needs and resources of the borrower. Balloon notes that require only the payment of interest currently provide an attractive way to provide liquidity for a child or grandchild without the immediate burden of substantial loan payments.

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EXAMPLE:

Parent is in the current top federal income tax bracket of 35% and lends $300,000 by means of a thirty-year promissory note to Child and Child's Spouse so they can purchase a new home. The promissory note is secured by a mortgage so that the Child can deduct the interest payments. The interest rate is at the 4.45% December 2008 long-term applicable federal rate and is payable on December 31 each year, interest only, with the principal due only at the end of the thirty-year term. Parent decides on a year-by-year basis whether to forgive or collect the interest, depending on Parent's own cash needs.

If Parent forgives the interest at the end of the first full year of the loan, he or she will be forgiving a total of $13,350 in interest, which is less than the $24,000 combined total in annual exclusions gifts in 2008 Parent can make to Child and Child's Spouse. The tax rules still require Parent to report the forgiven interest for income tax purposes, and the forgiveness results in an out-of-pocket cost to Parent of $4,672 ($13,350 x 35% marginal tax rate). Because the tax rules treat the loan recipients as actually having paid the interest to Parent, they are entitled to an income tax deduction in the amount of $13,350, which saves them $4,672 in income taxes, assuming that they also are in the top income tax bracket. From the perspective of viewing the family as a single economic unit, the transfer is a wash and Parent has in effect shifted the tax benefit on a dollar for dollar basis to Child and Child's Spouse.
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As the example in the box above illustrates, it is possible once the loan is in place for the senior generation lender to forgive interest and/or principal from time to time (mindful of the $12,000 annual exclusion limit available in 2008 and the $13,000 annual exclusion limit available in 2009) if the lender wishes to avoid making a taxable gift. Of course, intrafamily loan arrangements should not be created with the implied or expressed understanding that the loan will be forgiven over time; otherwise, there is the risk that the IRS will treat the entire loaned amount as a gift upon inception, which can have unintended gift and estate tax consequences. In addition, special rules apply to intrafamily loans that exceed $10,000 but are less than $100,000, and should be reviewed carefully.

It is important to emphasize that loans from a senior generation family member to a junior generation family member may be made for any number of purposes. Specifically, it may be attractive to loan money to a junior generation family member to afford that family member with liquidity to make investments. To the extent those investments generate a return in excess of the applicable federal rate of interest due on the loan, the senior generation family member has enabled the children to pocket that excess, gift tax-free.

Please contact us if you have any interest in exploring the opportunities with intrafamily loans further.

We hope you found this update helpful. Please contact us with questions about any of these items or anything related to your estate planning needs.



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