Does Income Ta Planning Now Trump Estate Ta Avoidance?

o The pressure to "forum shop" will increase as taxpayers attempt to move their tax domicile to states like Florida that have lower taxes. Florida cannot amend its state estate tax without a constitutional amendment (an unlikely event given the number of retirees in south Florida).

With a small number of Americans subject to a federal estate tax, more planners and clients will focus on saving income taxes. Among the income tax planning opportunities are:

==A client who is funding benefits or obligations (e.g., college or support costs) for someone (e.g., a college age child or a parent in a nursing home) who is in a lower income tax bracket should consider adopting approaches by which the ordinary income or capital gains of the client are shifted to the lower tax rate taxpayers. For example, assume a client has a rental property that produces ordinary taxable income of $100,000 per year. The client is in the 40% federal bracket, but his 5 children and 10 adult grandchildren are all in an effective tax bracket of 15%. The client places the rental property in an FLP and retains a 2% general partnership interest. Over a few years, he transfers the FLP interests to a spray trust for his descendants. The trust has the right to spray income among his descendants. Using the income tax brackets of the 15 trust beneficiaries, the overall annual tax on his rental property would drop by up to $24,500.

==When clients want to make charitable bequests, they should consider funding the charitable bequests with retirement or other assets that would have created "income in respect of a decedent." For example, assume a client has a desire to pass $30,000 to a charity at the time of his death. He holds an IRA worth $25,000. The client could name the charity as beneficiary of his IRA and provide in his will that the estate pay to the charity the difference between $30,000 and the IRA value at his death. Assume the IRA was worth $20,000 at death and the client's only heir is in a 40% state and federal income tax bracket. The passage of the $20,000 in IRA funds to charity would save the heir up to $8,000.

==Investments in trusts and estates may change to those that are more tax effective. Net after-tax returns will become a critical part of investment evaluations. This trend is already evident in the growth of total return trusts. One motivation for total return trusts is the desire to move away from strict definitions of income and principal that tend to distort fiduciary investment decisions.

==While basis issues always have been an aspect of global planning, the income tax benefit derived from basis planning often was eclipsed by the need to minimize a confiscatory federal transfer tax. With the transfer tax less of an issue for most Americans, the income tax planning benefits of planning for the basis of assets is receiving new attention. When an asset is includible in a taxable estate, the asset generally obtains a step-up in basis to the asset's fair market value.

For years, much of the conflict between tax practitioners and the IRS has been over the "undervaluation" of assets on federal transfer tax returns. That world is getting ready to change. With the significant reductions in the number of taxable estates, the IRS and tax practitioners may be ready to change roles. When there is no federal estate tax due, practitioners will drive values up to obtain a greater step-up in basis, while the IRS will begin to challenge the higher values.

For example, assume that in 2006 (i.e., when the federal estate tax exemption is equal to $2 million) a terminally ill client owns 40% of a business worth $4 million. The estimated valuation adjustments are 30%. The client's sole heir owns the remaining 60% of the business. The client's remaining assets are $200,000. If the decedent dies without any changes, the step-up in the 40% business interest would be $1,120,000. Assume instead, the client purchases a 15% minority interest from the heir for a note for $420,000. At the client's death, his 55% interest is worth at least $2.2 million. The note and remaining assets would produce a non-taxable estate of $1,980,000, while providing a step-up in basis for the 55% interest to $2.2 million. Assuming the heir sold the business after the client's death, the new step-up in basis would save approximately $216,000 in capital gain taxes, assuming a 20% applicable rate.

==For years, clients and planners have used Income Defective Trusts to reduce a client's federal estate taxes. An Income Defective Trust uses the differences in the income and grantor tax rules to create a trust that remains taxable to the donor for income tax purposes, while the trust assets are removed from the grantor's taxable estate. However, with the recent increases in the federal estate tax exemptions, the gap between the income tax and transfer tax rules may create planning opportunities for Estate Defective Trusts. Such trusts are created purposely to have the trust income taxable to the trust or its beneficiaries, but to have the trust assets remain in the grantor's taxable estate.

An Estate Defective Trust ("EDT") has two principal income tax-related benefits. First, the tax on the income of an EDT is allocated to either the trust or its beneficiaries. The EDT can effectively permit a grantor to use the lower income tax brackets of the trust beneficiaries to reduce the overall income taxes of the family. Second, many clients hold low basis assets (e.g., a family farm or business). A client may want to gift the asset to family members, but does not want to lose the benefit of the step-up in basis which occurs at death. The client can place the asset in an EDT. Beneficiaries will receive the current income benefit of the asset, but the asset will remain part of the grantor's taxable estate, permitting a step-up in basis.

Benjamin Franklin said that only taxes and death are inevitable. As long as we have taxes, tax avoidance will remain a major motivation for many clients. With federal death taxes no longer impacting the vast majority of Americans, the avoidance of state and federal income taxes and state estate taxes are becoming the prime tax avoidance motivation.

John J. Scroggin, J.D., LL.M., is an estate planning attorney in Roswell, Ga. And author of "The Family Incentive Trust," published by The National Underwriter Company. He can be reached via e-mail at [email protected].