A bold new era began on January 1st for estate planning attorneys and their clients.  Despite December efforts in Congress to pass legislation amending the estate tax to either permanently reform the system or provide a short term patch, the Senate failed to agree on and pass any legislation regarding the estate tax whatever.  Consequently, on January 1st, the post-2009 provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) are in effect, and for the first time since 1915, our country has no estate tax.  What does this mean?    

For starters, here is what we do know.  First, effective January 1, 2010, under current law, the federal estate tax is repealed for any person dying on or after 12:01 a.m., on that day, or any time in the next twelve months.  In theory, this means that any amount can be transferred to beneficiaries at death as long as death occurs in 2010.     

Second, the federal generation-skipping transfer tax (GSTT) also is repealed for one year, effective the same day.  So it should make no difference whether inherited wealth is left to children, grandchildren, great-children, great-nieces or nephews, etc.  The law will no longer penalize those who die and by will or trust provisions effective at death skip one or more generations and benefit younger family members, either by direct outright bequests or by creating long-term trusts.    

Third, the federal gift tax is NOT repealed.  The lifetime gift tax exemption will continue to be limited to $1 million, but the top gift tax rate will drop from 45 to 35%.  This seems to be an intentional effort by Congress to attempt to limit the amount that wealthy individuals will give away in 2010.    

Fourth, the stepped-up basis rules are repealed for 2010 and replaced with a modified carryover basis regime.  Before 2010, the income tax basis of property received by inheritance was “stepped up” to the fair market value of the property on the day the decedent died.  Under the new rule, the basis of property acquired from a decedent is the lesser of the decedent’s adjusted basis or the fair market value of the property on the date of the decedent’s death, whichever is lower.  There will be two exceptions to the new rule:  (1) the executor under a decedent’s will can allocate up to $1.3 million to increase the basis of assets received from the decedent; and (2) the executor also will be able to increase the basis of additional assets passing to the surviving spouse, either by outright bequest or in a particular type of trust for the benefit of the spouse (QTIP trust).  Remember that the $1.3 and $3 million amounts refer NOT to asset values, but to the amount of permitted basis increase that can be allocated.     

The effect of carryover basis is an income tax increase for wealthier families.  The rules for allocation will be complicated, and we will deal with that process in a separate article.  The bottom line to remember here is that identifying and preserving tax basis records will become extraordinarily important.  For the first time in recent memory, a beneficiary may have to substantiate the decedent’s basis in inherited property.    

Under the current law, all of these changes are scheduled to come to an end on January 1, 2011.  Effective on that date, under the “sunset provisions” of EGTRRA, the federal estate and generation-skipping transfer taxes both come back into existence with exemptions of only $1 million and a 55% top tax rate (with an additional 5% surtax for some large estates).  The federal gift tax continues with the same $1 million exemption and a 55% top rate, meaning all three taxes (estate, GSTT and gift) are again united.  Carryover basis is repealed and the stepped-up basis is reinstated.    

So what does this all mean and what should our clients be doing? No one expected the scheduled estate tax repeal to occur. As late as December 1st and after, commentators in the legal world and Washington fully expected Congress to pass either permanent estate tax reform or a temporary patch extending the 2009 exemptions and rates through at least part of 2010 to give Washington time to wade through health care reform and properly deliberate regarding the numerous issues involved with the estate tax.  Consequently, there is ”massive confusion” (in the words of Senate Finance Committee Chairman, Max Baucus) regarding what Congress will ultimately do and the best course of action for estate planning clients now that the unthinkable repeal has occurred.    

Basically, in 2010, one of four things will occur:  (1)  Congress will act to reenact the estate tax (and GSTT), retroactive to January 1st.  This would seem to be the most likely scenario, but it may be very difficult for Congress to pull together the necessary votes.  Neither Republicans nor Democrats will  relish the thought of restoring an unpopular tax in an election year.  Also, if the tax is reenacted retroactively, there are certain to be constitutional challenges.  The Chief Tax Counsel to the House Ways and Means Committee, John Buckley, has announced his opinion that reenacting the estate tax and GSTT retroactively would be unconstitutional.  (2) Congress will reenact both taxes in 2010, but will not attempt to make them retroactive.  This likely will depend upon how early in the year the matter can be brought to a successful vote.  Action in the first couple months almost certainly will date back to January 1st, whereas if the estate tax becomes a political football and action is delayed until late in the year, the possibility of a retroactive application decreases.   (3)  Congress will take no action, allowing the repeal to stand for 2010, with a return to the prohibitive tax rates and low exemptions scheduled as part of EGTRRA for 2011.  (4) Congress will not succeed in reenacting the estate tax and GSTT for 2010, but will act shortly to repeal carryover basis and restore the stepped-up basis.     

What should our clients be doing now?  First and foremost, do not lose sleep over the estate tax situation.  We are monitoring the commentators and Washington sources very closely and will keep you informed.  If you are worried about your specific situation, do not hesitate to contact one of us to discuss your concerns.     

Second, we will be looking very closely at the unique planning opportunities that may be presentedby the temporary absence of the estate tax and GSTT and will be happy to make specific recommendations.  Depending on the likelihood of retroactive reenactment of the tax (which may or may not become easier to predict in the next couple weeks), this may be the ideal time to pursue aggressive gifting with payment of some gift tax at the reduced rate, use of discounts, and creation of grantor-retained annuity trusts (GRATs) and similar devices to take advantage of  the current law.  At the same time, we will advocate caution to ensure that a return of the tax does not cause undesirable consequences for transactions carried out early in the year.  We also will be reporting to you on how the federal law changes impact the Illinois estate tax (as well as other states’ estate taxes) and similar issues that may affect your planning.    

Third, regarding traditional estate planning, we are incorporating alternative language in our estate planning documents designed to provide the best tax consequences no matter whether the estate tax and/or carryover basis does or does not exist at the time of death.  For clients who already have documents in place, remember that we have been using “trust protector” provisions (providing for amendment of the document even after death by a third party) for a number of years.  The trust protector concept is specifically designed to protect and implement a client’s wishes regarding disposition of their assets even in the event of tax law or other changes that may unfavorably impact the planning a client put in place before death or mental disability made amendment by the client impractical. For the short-term, the trust protector provision could be implemented as needed if a client were to die with older out-dated planning in place. In the case of a decedent whose documents did not include a trust protector provision, a proceeding could be brought in state court to amend or “reform” the document.    

Finally, we will be contacting you at an appropriate time to suggest a meeting, as periodic updating of your estate plan is always a good idea, even in times not as tumultuous as these.  But do not hesitate to pick up the phone or send an e-mail to us at any time that you have thoughts or concerns that you would like us to address immediately. Your peace of mind is always our ultimate goal.  Have a happy and prosperous 2010 and stay tuned!

Here is a scenario to ponder.  A Debtor issues two Promissory Notes, one to Creditor A and the other to Creditor B.  The Note to Creditor A is dated earlier and is secured by a properly perfected pledge in the Debtor’s stock.  The Note to Creditor B is secured by a properly perfected and filed UCC financing statement on all assets of the Debtor.  There is no Intercreditor and Subordination Agreement between Creditor A and Creditor B.  Debtor defaults.  Would you rather be Creditor A or Creditor B?

Article 9 of the UCC addresses a number of priority scenarios when different creditors lien against the same asset. See 810 ILCS 5/9-317 to 810 ILCS 5/9-339. However, it does not provide much guidance as to the practical economic effect of two creditors who properly perfected their liens against different assets.

In the scenario above, Creditor A may enforce its pledge to gain voting control of the Debtor and attempt to sell the business.  However, Creditor B still has a valid lien against the Debtor’s assets that will not be extinguished by Creditor A assuming control of the Debtor.  Creditor B can still proceed against the assets and recover its obligations, possibly leaving Creditor A with a shell company.

Creditor A would be in a better position if it had an Intercreditor and Subordination Agreement with Creditor B that ensured Creditor A was paid off before Creditor B.  However, this scenario also presents the lesson to creditors often cited by Alastor “Mad-Eye” Moody in the Harry Potter books – “Eternal Vigilance.”  Know what your debtors are up to and what encumbrances they are racking up.

This scenario also highlights certain limitations of using stock pledges to secure debt.  These will be explored further in a later blog.

Washington Sources indicate that Congress finally may be getting serious about acting to amend the federal estate tax.  A House and Senate negotiating committee has been working to achieve a compromise among various bills proposed in the House and Senate, all aimed at preventing the scheduled repeal of the estate tax next year and replacing it with permanent reform.  The recent compromise would freeze an individual’s exemption at $3.5 million and the top tax rate at 45% (the current 2009 levels).  Based on the alternatives, this may be good news indeed.

Recent proposals would have set the tax rates on decedent’s estates considerably higher.  H.R. 2023 was offered by Democrat Jim McDermott.   That bill would have lowered the applicable exclusion amount available to an individual (the amount that would pass free of estate tax at the death of an individual if not utilized during lifetime for gifting) (the “exclusion”) from $3.5 million to $2 million.  It would have made the exclusion portable between spouses.  (Portability means that a surviving spouse would have the use of any remaining exclusion not utilized during life or at death by the first spouse to die — not currently permitted).  However, that would have limited a married couple to $4 million in total combined exclusion, down from the current $7 million. 

Worse, Representative McDermott’s proposal would have eliminated the current deduction for state death taxes.  An estate currently can take a deduction from the federal estate tax for estate taxes paid to any state.  Most states that have an estate tax still use similar systems based on the old credit from the estate tax for death taxes paid to a state.  This would have meant a substantial estate tax increase — combining the federal estate tax rate with an assumed rate equal to the old state death tax credit, taxable estates of $4,040,000 would have paid a combined tax rate of over 56%, with taxable estates exceeding $10,040,000 owing combined federal and state taxes at a rate of 71%! 

Other bills would have set the limits at far more sane levels.  A recent budget passed by the Senate would have increased the exclusion to $5 million per person and lowered the top estate tax rate to 35%.

Other related issues to watch with concern include what Congress will do with the current step-up in the income tax basis for assets passing from a decedent, the use of discounts in valuing lifetime gifts of closely-held stock and other property, and the lifetime gift tax exemption of $1million, to name a few.  Watching Congress attempt to reach final passage of a permanent amendment to the estate and gift tax portion of the Internal Revenue Code may well resemble a good NBA or NHL playoff game — unpredictable at best.  We will do our best to keep you informed.

Fender Musical Instruments Corporation, one of the acknowledged innovators in electric guitars, just lost a six year battle in which it was seeking to trademark some of the best-known (and best-loved) electric guitar body shapes, shapes it created more than fifty years ago.  Fender rocked the music world with its Stratocaster and Telecaster guitar and bass styles in the mid-1950’s, and the styles have become two of the most recognizable guitar shapes in the world.  Unfortunately for Fender, it made too many mistakes over the last fifty years and cannot fully capitalize on its innovation, as the United States Patent and Trademark Office Trademark Trial and Appeal Board has ruled (.pdf file) that Fender will not enjoy trademark rights in its iconic designs.

According to the evidence cited in the ruling, the 1960’s and 1970’s saw an explosion of guitar manufacturers issuing their own versions of guitars and basses modeled directly from the Fender Stratocaster and Telecaster body styles.  One manufacturer even testified that he obtained Fender guitars in the 1970’s and traced their bodies to create his own template to manufacture identically-shaped guitars.  Fender not only failed to object to the imitations, but also acknowledged them in advertising by exhorting consumers to buy “the true Fender sound” instead of one of the many “look-alikes.”  Finally, Fender actively pursued companies who used their trademarked names “Stratocaster” and “Telecaster,” and even pursued companies for copying the shape of their headstock (for the unitiated, that would be the opposite end of the instrument), but never pursued any claim of trademark regarding the body shape.

The end result is devastating - though the Board acknowledged that Fender had created iconic designs (one of which even appears as the generic picture of a guitar in the dictionary and in the clipart attached to this post), it determined that Fender could not assert a trademark in those designs because they are now a generic element that cannot be associated with a single manufacturer.  The Board said that Fender further compounded this problem by failing to even try to protect its body designs from copying while proving that it knew how by jealously protecting other design elements of the guitar.  The company has lost untold potential licensing fees from other manufacturers who testified they could not remain in business if they did not manufacture guitars using the classic Fender designs.

The opinion provides some simple and important lessons to anyone hoping to obtain or retain a trademark:

1. If you create a distinctive and recognizable variation of some consumer good, act to preserve your rights immediately;
2. Do not tolerate imitations or homages, no matter how flattering they may be; and,
3. Take some time to review all the possible design elements that may be subject to trademark or other intellectual property protections, to be sure that you are protecting all of your rights equally and sufficiently.

One of the few perks that a taxpayer can bestow upon his or her beneficiaries is the so called “step up” in basis under Section 1014 of the Internal Revenue Code. This Section generally permits the tax basis of property owned by the decedent to take a tax basis equal to fair market value as of the date of death of the decedent.  This Code provision is usually very helpful for taxpayers, particularly those who may have held appreciated securities or real estate for many years.  Depending upon the size of a person’s estates (taxable or not) the ability to step up the tax basis of assets may be outweighed by the ability to transfer the assets out of the taxable estate and avoid the usually greater marginal estate tax rate.

The recent carnage in the markets however, has left taxpayers with the unpalatable prospect of a step down in basis.  Section 1014 merely specifies that the basis of property acquired from the decedent is valued at fair market value as of date of death, independent of whether the fair market value is greater or less than basis.

For example, say Mr. G. owns 1,000 shares of AIG, which he purchased for $100 per share way back in October, 2000.  If Mr. G sells the AIG shares for $1, he incurs a long term capital loss of $99,000 ($100,000 - $99,000).  If he dies owning the shares, the tax basis of the shares plummets to $1,000.

What is a planner to do?  The first alternative is for the client to sell the property prior to death, thereby recognizing the loss.  The second alternative, if the client is married, would be to transfer the property to the healthier spouse so that he or she would have the opportunity to time the sale of the asset before his or her later death.  Section 1041(b)(2) of the Code provides that a spouse takes the donor’s basis in the transferred property.  The result is not the same however, if the donee is not the donor’s spouse.  In that case, it is a heads I win, tails you lose for the IRS.  If the fair market value of the property is less than the donor’s basis, then for purposes of recognizing any loss, the donee takes as his or her basis the fair market value of the property rather than the donor’s basis.

Example 2:  Assume Mr. G gives the AIG stock to his son, Junior.  Junior later sells the shares for $1.  He does not recognize any gain or loss because his basis is now $1.  He will later recognize gain or loss to the extent that the sales price of the shares is more or less than $1.

The above examples illustrate that the devastating meltdown in financial and real estate assets is turning some transitional estate planning on its head.

A recent U.S. Supreme Court decision illustrates the importance of making sure that clients properly designate the beneficiaries of their retirement plans. In Kennedy v. Plan Administrator for DuPont Savings and Investment Plan 129 S. Ct. 865 (2009) a unanimous Supreme Court determined that the plan administrator acted properly in paying benefits to the divorced spouse of the deceased plan participant.

In Kennedy, the decedent, William Kennedy was an employee of DuPont and participant in its savings and investment plan (the “Plan”). William later married Liv Kennedy and named her the beneficiary of the Plan. William later divorced Liv, but did not change the beneficiary designation. The divorce decree did specify however, that Liv waived any rights to any retirement plan, pension plan or like benefit program. When William later died, DuPont paid the Plan benefits to Liv, in accordance with its obligations under ERISA. The estate of William sued DuPont alleging that Liv had waived her benefits in her divorce and that DuPont had violated ERISA by paying the Plan benefits to Liv. 

The Estate was successful in the District Court; however, the Fifth Circuit Court of Appeals reversed.  The Supreme Court affirmed the Appellate Court decision, noting that the Plan provided a simple way for William to change the beneficiary designation.  

This is a nice lesson in human nature and the importance of properly reviewing beneficiary designations after a divorce or other important life event.  Liv knew that equitably, she was not entitled the Plan benefits, because she had waived them in the divorce. Her argument prevailed however, because of the specific requirements that ERISA imposes on plan administrators to pay plan benefits to the designated beneficiaries.  Kennedy is a sad reminder to always review beneficiary designations after a divorce or other important event.

The Florida Supreme Court will shortly deliver its decision on the question certified to it by the Eleventh Circuit under FTC v. Olmstead, et al, 2008 US App LEXIS 11393 (May 29, 2008) as to whether creditors of single member Florida LLCs are limited to charging order remedies.

Ever since LLCs came into existence, legal and financial planners have taken advantage of the asset protection granted by the limited liability company acts (“LLC Acts”) limiting creditor remedies to charging orders. A charging order provides a creditor with a lien on the debtor’s distributional interest in the LLC. By denying the creditor the right to levy on the debtor’s membership interest and obtain voting rights, it limits their remedy to the amount of distributions (if any) made by the LLC.

The charging order remedy originated in common law to protect non-debtor partners from being unwittingly forced into partnership with a creditor. Nevada has extended this concept to certain small business corporations. See Nev. Rev. Stat. 78.746(1)(bb) and Nev. Rev. Stat.78.746. However, this justification does not exist in a single member LLC. Even though the LLC Acts do not limit charging order protections to multi-member LLCs, the plain language of the statutes is under attack in cases like Olmstead.

Charging order protections for single member LLCs were first overturned by the United States Bankruptcy Court for the District of Colorado in In re Ashley Albright, 2003 Bankr. Lexis 291. However, that case has not yet been followed by any state court interpreting its own LLC Act. The decision of the Florida Supreme Court in Olmsteadcould be the next domino to fall. It is time for planners to reassess whether single member LLCs meet their intended purpose and to what extent alternative asset protection plans can avoid judicially created creditor remedies.

Congress continues with efforts at permanent estate tax reform. In January, Harry Mitchell (D) of Arizona introduced a bill that would reform the estate and gift taxes permanently.

The key parts of the bill would:   

•  Make the estate and generation skipping taxes  permanent;

•  Increase the applicable exclusion amount to  $5 million, phased in as follows:

          •  For calendar year 2010, $3,750,000
          •  For calendar year 2011, $4,000,000
          •  For calendar year 2012, $4,250,000
          •  For calendar year 2013, $4,500,000
          •  For calendar year 2014, $4,750,000
          •  For calendar year 2015 and thereafter, $5,000,000;

•  Index the applicable exclusion amount for inflation, beginning in 2016; 

•  Reunify  the gift tax exemption to the estate tax applicable exclusion amount;

•  Limit  the top estate and gift tax rate to the maximum capital gains rate for taxable estates of up to $25 million, and double that rate for estates over $25 million;

•  Index the $25 million threshold for the higher rate for inflation after 2014;

•  Repeal the estate tax deduction for state death taxes;

•  Retain the present rules that provide for a step up in the income tax basis of assets at death;  and

•  Allow the unused applicable exclusion amount of the first spouse to die for use by the surviving spouse.

It will be interesting to see how Congress “fixes” the estate tax. We are now less than 10 months from a one year repeal  and all of the interesting subplots that would bring.