By John J. Scroggin

It appears unlikely that Congress will pass any transfer tax reform in 2010. As a result, 2010 could be the best of times for gifting by affluent clients. Part I of this article on gifting in 2010 (see Newsstand e-mail 7/26/2010) by noted author and planning expert John J. Scroggin considered the multiple factors that encourage making gifts this year. Part II covered select gift planning opportunities available this year (see Newsstand e-mail 7/26/2010). Part III of the article, below, covers 2010 strategies and planning for terminally ill clients.

Trusts created in 2010. Assume a married client is terminally ill and will clearly pass in 2010. The healthier spouse can transfer assets to the terminally ill spouse who redrafts dispositive documents to establish a testamentary bypass and/or QTIP trust. Use of both trusts will allow for a greater step-up in basis under Code Sec. 1022 and provide for a broader group of beneficiaries (i.e., as opposed to just the surviving spouse). If the ill spouse dies in 2010, neither trust will be included in the healthy spouse’s estate in later years and the trusts may provide asset protection to the beneficiaries.

What happens to the basis of the assets bequeathed back to the surviving spouse in trust? For 2010, Code Sec. 1022(d)(1)(C)(i) provides that if assets were gifted to the decedent within three years of the decedent’s death, no basis adjustment may be allocated to the assets. However, Code Sec. 1022(d)(1)(C)(ii) provides that, unless the asset being gifted was acquired by the gifting spouse “by gift or by inter vivos transfer for less than adequate and full consideration in money or money’s worth,” the asset can still receive a basis adjustment pursuant to Code Sec. 1022 . Code Sec. 1014(f) provides that Code Sec. 1014(e) (which eliminates a step up in basis on certain assets gifted within a year of demise) is revoked for 2010.

Basis planning in 2010. With no estate tax and the potential under Code Sec. 1022 of up to $4.3 million in basis adjustments, basis planning for terminally ill clients may trump any estate tax planning in 2010. A few examples:

  • If a client is expected to pass in 2010 and owns assets which might be discounted in value, terminally ill clients should consider how to obtain a higher basis for heirs by eliminating the expected discount. For example, assume a married client owns 40% of an LLC which owns several real estate properties. If the estate’s total appreciated value (i.e., the difference between fair market value and the client’s basis) is less than $4.3 million, consider (before death occurs) redeeming the client’s LLC interest for one or more of the underlying pieces of real estate (i.e., direct ownership of the real estate eliminates the LLC minority ownership discount). In the alternative, another LLC member (e.g., a spouse) could gift or sell an 11% LLC interest to the client, permitting the application of a control premium to the LLC value in the decedent’s estate. Obviously, there are other factors which may adversely impact such a plan (e.g., maintaining family control of the asset).
  • Assume a terminally ill married client owns an asset with a basis of $500,000 and a fair market value of $200,000. If the client dies, the asset’s basis will step down to its fair market value, resulting in the termination of the tax benefit of the inherent loss in the asset. Instead, the terminally ill client could gift the asset to a spouse or another heir. If the donee subsequently sells the asset for a value from $200,000 to $500,000, no taxable gain will be reported on the sale.
  • The tax losses of a decedent are not normally carried over to the estate or heirs, but 2010 offers a unique opportunity. Assume a client holds an asset worth $1.0 million with a basis of $3.0 million. If the client dies owning the asset, the basis will step down to $1.0 million (i.e., its fair market value) and the inherent loss of $2.0 million will disappear. However, for decedents dying in 2010, pre-death tax losses can increase the step-up in basis of the remaining assets in the estate. If the loss asset were sold before death and the client died in 2010, up to an additional $2.0 million in basis adjustments would be allowed for the estate’s assets.
  • A client’s wife is terminally ill, but owns no assets. In 2010, the donor transfers low-basis assets to the spouse, who revises her will to provide that those specific assets pass into one or more trusts (see the comments at the start of this article). The assets could receive a basis step-up of up to $4.3 million pursuant to Code Sec. 1022.

Charitable bequests. Many clients make charitable bequests, but if a client is expected to die in 2010, there is no 2010 estate or income tax benefit from making a charitable bequest. To obtain the benefits, make the gift before the client’s death and take advantage of the charitable income tax deduction for the grantor to reduce the grantor’s income taxes. For example, moving a $50,000 charitable gift into the last year of the client’s life could save the family up to $17,500 in federal income taxes (i.e., $50,000 times the 35% top federal income tax rate in 2010). Make sure the dispositive documents are changed to remove the charitable bequests, or the charity might have a claim against the estate. Also make sure the client has sufficient income to use the charitable income tax deduction.

As an alternative to the above example, the will could be changed to make the bequest of $50,000 to an heir in 2010 and request that the heir make the charitable contribution. If the $50,000 gift is an asset with a low basis in the hands of the decedent, funding it through the estate could allow for an increase in the basis using the 2010 basis adjustment rules and might provide for a larger charitable deduction for the heir who makes the charitable contribution.

Planning for gift splitting. Code Sec. 2035(b) does not include gift tax payments in the donor’s estate to the extent that the gift tax was paid by the decedent’s spouse pursuant to a gift-splitting arrangement. The relevant tax policy is that there is no incentive to restore the decedent’s estate under Code Sec. 2035 because no amounts were removed from the estate by the gift tax payment. This offers a planning opportunity. If one spouse is in poorer health than the other, consider making a gift splitting election and have the healthier spouse (assuming he or she has the available funds from their own resources) pay the total gift tax (See: PLR 9214027 (Jan. 7, 1992)). This eliminates the chance that the gift tax will be included in the unhealthy spouse’s taxable estate. What if neither spouse is in great health? Consider gift splitting and having each spouse pay half the gift tax, increasing the chance that at least one of them will survive beyond the three years.

Death-bed gifts. Death-bed annual exclusion gifts are a significant planning tool. However, in Rev Rul 96-56, 1996-2 CB 161, IRS ruled that if the donor dies before a gift check clears his or her account, the gift is not removed from the estate. In general, charitable death-bed checks do not have to clear the decedent’s accounts before death, while non-charitable gifts do have to clear the account.

Death-bed gifts may make sense for clients who will pass after 2010. Assume a terminally ill client has no descendants, but does have a taxable estate in 2011. In her will she made 20 special bequests of $5,000 each to friends, with the balance of her estate passing to nieces and nephews. The will provides that the residue pays any estate tax. Have the client make the $100,000 in transfers during life as annual exclusion gifts and revise the will to eliminate those bequests. Assuming the client dies after 2010, converting the bequests to annual exclusion gifts saves the nieces and nephews $41,000 to $60,000 in estate taxes (i.e., the range of effective estate tax rates in 2011).

Estate planning advisors need to prepare their clients for the looming 2011 tax changes and consider the unique planning opportunities of 2010. Congress’s decision or inability to deal with EGTRRA’s sun-setting provisions in 2010 is going to keep the estate and tax planning industry busy for some time.

As chaotic as the last few years have been, there is at least one remaining time bomb in EGTRRA. Section 901(a) of EGTRRA reads: “All provisions of, and amendments made by, this Act shall not apply to… (2) in the case of title V [the transfer tax changes] to estates, of decedents dying, gifts made or generation skipping transfers, after December 31, 2010.” Section 901(b) reads: “The Internal Revenue Code of 1986… shall be applied and administered to years, estates, gifts and transfers described in subsection (a) as if the provisions and amendments described in section (a) had never been enacted.” The inability to understand the full implications of the underlined language will add to the tax planning chaos after 2010 and will undoubtedly result in the creation of new and highly questionable planning proposals.

Author: John J. Scroggin, AEP, J.D., LL.M., member of the Georgia and Florida Bars and practices in Atlanta. He is a nationally recognized speaker and author of over 250 articles and columns on estate, tax and business planning.