2012 was one of the most significant years in estate planning history. While the outcome of the election, and perhaps even 2013 tax legislation, may be known by the time you read this checklist, the bottom line is that the fear of major unfavorable changes in the gift, estate and generation skipping transfer (GST) tax laws drove clients like never before in history to engage in gift planning in 2012. Now that the gift wave has subsided, practitioners have to deal with how those gifts affect 2012 Form 1040 compliance. The implications are legion and often surprising. Perhaps more than ever before in history, practitioners may have to (or would be advised to) meet with the client’s estate planning attorney before preparing the client’s personal 1040, trust 1041s and 1065s and 1120S returns for entities involved in 2012 gift planning. The points below summarize some of the myriad of issues that practitioners might confront for the first time.
√ Extend: Gift Tax Returns for 2012 will be the largest numerically in terms of number of returns, and largest in terms of wealth transferred in history. Extend will be the operative word. Practitioners should really consider extending any income tax return for any client that made 2012 gifts so that the automatic gift tax extension will also be received. If not, the gift tax return should be extended.
This will be necessary as the number, size and complexity of returns will warrant more attention than an April 15 filing date will realistically permit. Further, practitioners will have to consult with the clients other advisers (insurance, estate planning attorney and wealth manager) to identify gifts that they as CPAs may not have been informed of. All this will take time. If the new laws are not known, extending until they become known will be critical for many of the gift tax returns.
√ Late GST Allocations: Knowledge of the future of the gift, estate and GST tax may be essential if possible to determine the appropriate positions to take on 2012 gift tax returns, e.g. whether or not to allocate GST exemption to a particular transfer or not. For example, the client might contemplate making a late GST allocation on a 2012 gift tax return to protect a prior gift that was not initially intended to be GST exempt. This is not an esoteric issue only for the ultra-wealthy.
If in fact the GST exemption drops from $5.12 million to an inflation adjusted $1 million, as the law provided for 2013, it would be advantageous for many clients to make a late allocation of GST exemption to old insurance and children’s trusts that might otherwise not receive GST allocations. If the GST exemption does in fact drop in 2013, there may be no downside to making late allocations to old trusts if the GST exemption would be lost anyway.
√ Grantor Trust Returns: Most practitioners are familiar with revocable living trusts and reporting the income and deductions from such trusts on the client/grantor’s income tax return. However, the grantor trusts created in 2012 to take advantage of what many perceived to be disappearing tax planning opportunities are a different breed. Tax reporting for the common living trust is generally to simply have the trust use the grantor’s Social Security number and report all information on the grantor’s income tax return. This approach avoids the need to obtain a tax identification number or file a trust income tax return.
This simplified approach is permitted if the trust is a domestic trust, all income is reported by the grantor or the grantor’s spouse because the trust can be revoked by the grantor or a non-adverse party and the grantor or the grantor’s spouse are trustees. Treas. Reg. Sec. 1.671-4(b). But a trust that can be revoked would not achieve the transfer tax planning goals clients pursued in 2012 so that this reporting model is incorrect. The 2012 transfer tax planning trusts generally won’t be revocable and many won’t have the grantor as a trustee.
Practitioners have to modify their grantor trust reporting standards accordingly and be certain that separate Form 1041s are filed and appropriate grantor trust statements attached. This is important not only to properly report from a compliance perspective, but the filing of an independent return for these complex estate planning trusts could prove to be an important factor in demonstrating that the independence and formalities of the trust were respected. This could prove vital in the event of a later lawsuit or IRS challenge.
√ Who is the Grantor: Almost all trusts established that are grantor trusts, the person setting up the trust (“settlor” or “trustor”) is the grantor for income tax purposes. However, a planning technique known as the “beneficiary defective irrevocable trust” or “BDIT” has become more common and many were established in 2012 as wealthy clients endeavor to capture discounts and grantor trust status before possible changes in the law. In a BDIT typically a parent is the settlor, but as a result of a carefully drafted trust and the use of a Crummey power, the beneficiary of the trust, typically a child, is the grantor for income tax purposes. Care must be exercised to ascertain exactly who the intended grantor is before filing and potentially undermining the carefully sought tax result.
√ What Should be Reported: Many of the sophisticated estate tax planning trusts used in 2012 include a number of provisions or powers that can dramatically affect who owns which assets and who the beneficiaries are. Without understanding some of these unique nuances, not only might compliance be handled incorrectly, but the objectives of the entire plan may be undermined. For example, a “swap power” that provides the grantor, and sometimes another person, the right to swap or exchange assets outside the trust for assets inside the trust can instantly shift the ownership of valuable assets.
Many practitioners established 2012 trusts with cash or marketable securities intending in 2013 to have the client or another person designated in the trust exchange family business or closely held real estate interests for the cash in the trust. If such a ‘swap” was effected it would affect the 1120S or 1065 for the S corporation or LLC as well as the trust. While there would likely be documentation if a swap occurred, most estate planners do not document when nothing has occurred (i.e., no one has exercised the power). How can you know as a tax preparer that nothing has been done to affect trust assets without an affirmative statement from the person holding the power that it was not exercised? Failing to properly report such a transaction could have adverse effect on the entire estate plan, make the trust grantor 1041, the client’s 1040, and the entity’s return all incorrect. In addition to the swap power, some estate planners have commonly used the power to loan trust assets to the grantor without adequate security, or the power to add a charitable beneficiary.
Just like the swap power, if practitioners don’t confirm what, if anything, was done there may be no way to properly prepare multiple returns and the entire plan could be jeopardized. Given the dramatic surge in the number of these trusts that were completed in 2012 practitioners need to be alert and should corroborate in writing the status of these powers.
√ Schedule C and E Surprises: A common planning step in 2012 planning was to make gifts of interests in closely held LLCs. LLCs that may have been disregarded single member entities in prior years, or which could avoid their own filings as a result of a Qualified Joint Venture (“QJV”) election may now require their own returns rather than merely reporting on the client’s 1040 schedule C and E. Single member single purpose real estate LLCs will likely prove a common example.
Perhaps the biggest surprise for practitioners attempting to prepare 2012 1040s and entity returns is determining who owns what interests in the entity? Looking at last year’s K-1 and even the gift documentation won’t provide the answer. This is because many estate planners, especially near the end of 2012 used what are referred to as defined value clauses to effectuate gifts in 2012. These clauses fix in dollar terms the gift of interests in an entity or other asset made to a trust or other donee. So until the gift tax audit concludes it is impossible to know what percentage anyone owns. While there is scant if any law on how to report this, ignoring this reality on entity and client income tax returns might well be a factor the IRS uses in attacking the reality of these defined value clause mechanisms. Perhaps at minimum practitioners should consider reporting the estimated percentage transferred but attaching a statement to both the client’s and entity’s return disclosing the existence of the defined value clause and indicating that until its terms are resolved the percentage ownership interests are merely estimates that may have to retroactively be changed.
Conclusion
If this is all a bit unfamiliar, seek help from the estate planner who created the plan before filing any income tax returns for 2012. You don’t want to inadvertently undermine your client’s major 2012 estate planning.
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