Trusts and Estates
August 2003 VOL. 50, NO. 1
Statements or expressions of opinion or comments appearing herein are those of the editors or contributors, and not necessarily those of the association or section.
Contents
* Illinois amends the estate tax to offset EGTRRA reductions in state death tax credit
* How to tackle Hackl: Turning future gifts into present interests
This issue has three articles of extreme interest. The first article by David Berek of Chicago discusses recently signed legislation which de-couples the Illinois estate tax from the allowable federal estate tax death credit. This applies to all decedents dying after December 31, 2002. This change will generally increase the Illinois estate tax burden for Illinois decedents.
Next, we have an article from Jim Lestikow from Springfield, with comments on the recent Seventh Circuit decision in the Hackl case decided on July 11, 2003. The Seventh Circuit affirmed a prior Tax Court decision which denied the use of the annual gift tax exclusion for gifts of LLC interest. This case, along with the Strangi II decision (also discussed in this issue), strengthens the IRS attack on the use of family limited partnerships and other entities and resulting discounted values. Jim suggests possible solutions to the problems created by Hackl.
There is also a very practical article from Deborah Cole of Chicago, suggesting an estate planning checklist to help avoid inadvertent mistakes when planning our clients' estates.
Finally, we have summaries of five recent Illinois cases and the big IRS victory in Strangi II, plus some Odds and Ends.
We encourage our readers to submit material for publication. Please send both a hard copy and a computer disk or e-mail attachment containing your article (Microsoft Word preferred but not required) to either Mark E. Zumdahl (815) 625-8200 or Jim Say (815) 961-7931.
Illinois amends the estate tax to offset EGTRRA reductions in state death tax credit
By David A. Berek
On June 20th Governor Blagojevich signed into law legislation amending the Illinois Estate and Generation-Skipping Transfer Tax Act under 35 ILCS 405 applicable to decedents estates for deaths occurring on or after January 1, 2003. As amended, the new law insures that Illinois will continue to receive the same amount of tax from a decedent's estate as it has in the past, without regard to the reduction in the state death tax credit under Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). The new Illinois law effectively converts each dollar of pick-up tax lost to EGTRRA reductions into a new add-on tax, which has the effect of increasing overall death taxes. The law as amended, however, may not be what many practitioners who were following the progress of the various estate tax bills might expect. Rather, it is a new approach that is somewhat unique as compared to how other states have reacted. In order to fully analyze how the new Illinois estate tax works, this article will review the calculation of the federal state death tax credit, consider how Illinois is continuing to utilize the old federal calculation to impose the new state tax, and finally, compare how surrounding states have addressed the problem and what drafting tips can be utilized to perhaps reduce the amount of state estate tax payable generally.
The old Illinois pick-up eliminated under EGTRRA
Prior to the amendment to the Illinois estate tax law, Illinois defined the amount of the Illinois estate tax payable as the amount of the credit for state tax allowable under federal law. This credit amount is commonly referred to by practitioners as the "pick-up" tax. With the enactment of EGTRRA, however, the benefit offered by a state pick-up tax system is gradually eliminated. To offset some of the loss of tax revenue due to EGTRRA, Congress reduced the amount allowed as a state death tax credit by 25 percent per year from 2002-2004, and ultimately eliminates the credit in 2005.1 Although EGTRRA also includes a new provision allowing a deduction to the estate for state death taxes paid, this deduction is only slightly helpful to the estate, and it is of no assistance to Illinois.2 Thus, to recapture some of these lost revenues, Illinois legislatively reinstated the full amount of the pick-up tax due Illinois by modifying the Illinois definition of "state tax credit." The new law amends the definition of the "state tax credit" under 35 ILCS 405/2 to include that amount of the federal state death tax credit that would have been payable had the reduction under EGTRRA not been enacted. Therefore, for decedents dying between January 1, 2003 through December 31, 2009, Illinois will continue to receive the full amount of the federal death tax credit.
Calculation of the Illinois add-on tax
Prior to January 1st of this year, the amount of the Illinois pick-up tax was defined as the federal state death tax credit allowed, or calculated, pursuant to the table under § 2011(b)(2) of the Internal Revenue Code (the Code). As amended, the amount of the Illinois estate tax will continue to be calculated pursuant to the § 2011 table, but Illinois will seek to collect the full amount of the credit without regard to the percentage limitations on the credit under EGTRRA. Thus, each dollar of pick-up tax reduced by EGTRRA will be replaced in Illinois by a dollar of new Illinois add-on tax.
For example, assume a $2 million estate will incur total federal estate taxes of $780,800. The unified credit in 2003 is $345,800, leaving a balance due of $435,000. Under § 2011, the federal credit for state death taxes is calculated to be $99,600. Prior to EGTRRA, the estate would write a check for $335,400 to the U.S. Treasury, and a check for the full credit of $99,600 to the appropriate state. Under EGTRRA, however, the amount of the state death tax credit has been reduced by 50 percent for 2003; thus, the allowable credit in the above example for federal purposes would be only one-half of the $99,600, or $49,800. Therefore, the check to the U.S. Treasury would increase by $49,800 and the check to the state would be reduced by $49,800, resulting in the same overall liability of $435,800. With the amended Illinois add-on tax, Illinois receives the full amount that would have been due without regard to the reduction under EGTRRA, even though credit against federal estate tax is given for only one-half of such amount, resulting in an increased tax payment for Illinois estates of $49,800 in this example.
Assuming the numbers3 were exactly the same, if the year was 2005 when there is no allowable state death tax credit, the check to the U.S. Treasury would be the full liability of $435,800 pursuant to federal law, and the check to Illinois would be the full amount of the credit $99,600 pursuant to the new Illinois estate tax law. Thus, Illinois has created a new estate tax which is equivalent to the credit calculated under § 2011. Again, this only affects estates that have a federal liability, with the exception of year 2009 as discussed below.
Mechanics of the federal table
As explained above, § 2011 allows a credit for death tax paid to a state which is calculated under the § 2011 table.4 There are two points of which to be aware when using the table to calculate the new Illinois estate tax. First, the table is based on the "adjusted taxable estate" as that term is defined under § 2011(b)(3). The terms "adjusted taxable estate" and "taxable estate" are defined terms and may not be what some practitioners might naturally expect. For example, the "adjusted taxable estate" as defined under § 2011(b)(3) for use of the table is "the taxable estate reduced by $60,000." The "taxable estate" is defined under § 2051 as gross estate less deductions. But the estate tax under § 2001 is assessed on the (i) taxable estate, plus (ii) the amount of taxable gifts. Thus, when working with the table in arriving at the "adjusted taxable estate" prior gifts are not taken into account, because prior gifts are not a component of the "taxable estate." The second point to be aware of is that the table begins calculating the credit at $40,000. Therefore, if a decedent made lifetime gifts of $1 million, and left a "taxable estate" of $100,000, (i) for state death tax purposes the adjusted taxable estate would be $40,000 ($100,000 - $60,000), and under the table, no state death tax credit is calculated, although (ii) for federal estate tax purposes, there would be a "taxable estate" of $100,000, plus prior gifts of $1 million, less the applicable exclusion amount of $1 million for 2003, leaving an estate tax calculated on $100,000.
Drafting considerations and the surrounding states
As stated above, the Illinois estate tax will generally only be payable if there is a federal estate tax liability. This is because the Illinois law tracks the federal increases in the applicable exclusion amount through 2008.5 The Illinois law however, does not track the federal increase in 2009 to $3.5 million. Rather, the Illinois law makes specific reference to the exclusion amount used to calculate the Illinois state death tax credit as $2 million for the period 2006 through the end of 2009. The purpose of this reference is to limit the exclusion amount in 2009 to $2 million rather than the federal exclusion amount for 2009 of $3.5 million.6
If practitioners are looking to draft around the Illinois estate tax, the year 2009 is the only opportunity. For example, if a marital funding formula creates a credit shelter trust equal to the greatest amount not subject to federal estate tax, there will be an Illinois estate tax assessed on the difference between the Illinois exclusion amount of $2 million and federal exclusion amount of $3.5 million. This is applicable only in 2009. If the federal estate tax is fully repealed under EGTRRA in 2010, Illinois follows federal law and there will be no Illinois estate tax. Furthermore, if (i) EGTRRA sunsets in 2011 and we are back to a $1 million exclusion amount, and, (ii) § 2011(b)(2) sunsets under EGTRRA and the states once again receive the full state death tax credit, then Illinois again follows federal law, and the Illinois add-on estate tax essentially sunsets and we are back to a pick-up tax regime. Thus, the only year to consider drafting a second marital trust to avoid the Illinois estate tax would be in 2009. If a married client had a taxable estate in excess of $2 million in 2009, it may be desirable to create a second marital trust to exempt from Illinois tax a portion that was already exempt under the federal law because of the increased federal exemption of $3.5 million.7
Special drafting is necessary, or at least should be considered, however, in other states. For example, in Wisconsin, the legislature has "decoupled" from the federal law for deaths occurring after September 20, 2002 and before January 1, 2008. For deaths occurring within that period, the law defines the amount payable to Wisconsin as the "federal estate tax credit allowed for state death taxes as computed under the federal estate tax law in effect on December 21, 2000."8 Under this "decoupling" interpretation, Wisconsin does not recognize the EGTRRA decreases in the credit or the increases in the exclusion amount except for deaths occurring after December 31, 2007.9 This language may be familiar to Illinois practitioners because it closely resembles earlier drafts of proposed amendments to the Illinois estate tax.
Under a "decoupled" regime, the state applicable exclusion amount is less than the federal exclusion amount, thus it is possible to have an estate that is not taxable for federal estate tax, but subject to a state estate tax. In order to minimize the state estate taxes, the draftsman in a decoupled regime can incorporate a second marital trust for the amount that otherwise would be taxable for state purposes. This decision, of course, must be weighed against the underutilization of the federal applicable exclusion amount.
Other states bordering Illinois have adopted or maintained slightly different state estate tax regimes. Missouri and Michigan, for example, are pure pick-up tax systems, and as EGTRRA gradually reduces the amount of the state death tax credit paid to the states, the amount paid to these states will be eliminated.10 Indiana, Iowa and Kentucky each have had in place a separate inheritance tax that accommodates different classes of beneficiaries.11 Each state also imposed a state estate tax that in effect picks up any excess that would be allowed under the federal state death tax credit not accounted for under the state inheritance tax.
Conclusion
The focus of the new Illinois law is to capture the full amount of the state death credit as calculated under the federal table, just as in the past, whether or not the federal law will allow a credit for taxes paid to the state. Since the Illinois estate tax is only applicable when there is a federal estate tax (other than in 2009), there does not appear to be any need to draft around the law. Care should be taken in calculating the credit, however, in order to make appropriate estate tax estimates. And note that until 2005, when the credit ceases to be a credit and § 2058 becomes effective, there is no corresponding federal deduction for the add-on tax paid to Illinois.
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David A. Berek is a member of the Trusts & Estates Section Council of the ISBA. He is an attorney with Kirkland & Ellis LLP and is a member of the bar in Illinois and Florida as well as a Certified Public Accountant (IL). He can be reached at dberek@Kirkland.com.
1. The credit provided under § 2011(a) is reduced under (b)(2) by limiting the allowable credit to only 75 percent in 2002, 50 percent in 2003, and only 25 percent in 2004. Pursuant to § 2011(f), the credit is not applicable for the estates of decedents dying after December 31, 2004.
2. Pursuant to § 2058, the deduction is allowed for estates of decedents dying after December 31, 2004. When the Illinois estate tax becomes a full add-on tax in 2005 and the deduction is allowed, the calculation for the Illinois should become an interrelated calculation. The deduction is not as helpful as a credit, because while a credit offsets tax dollar-for-dollar, a deduction only reduces the amount subject to tax.
3. For example, the size of the estate, the amount of the unified credit, the applicable tax rate, etc.
4. The original legislation regarding the state death tax credit under § 2011 was introduced in 1924 and last significantly amended in 1926. The § 2011 table itself has not been amended since then. Under the law in 1924, the highest amount of the credit was 80 percent of the federal tax, and the federal estate tax at that time ranged from one percent to 20 percent. Thus, in 1924, the highest credit payable to a state was 80 percent of the estate tax (at a maximum rate of 20 percent), or 16 percent of the adjusted taxable estate, and from 1924 until the enactment of EGTRRA in 2001, the greatest amount of credit allowable to a state has been 16 percent of the adjusted taxable estate.
5. The applicable exclusion amount was adjusted under EGTRRA to $1 million in 2002 and 2003, $1.5 million in 2004 and 2005, $2 million for 2006-2008, and $3.5 million for 2009. In 2010 the estate tax is repealed, although the law will sunset at the end of 2010 and return to the law in effect prior to EGTRRA, which under prior law increased the applicable exclusion amount to $1 million in 2006, thus, in 2011 after sunset, the applicable exclusion amount would be $1 million.
6. Note that the intent is to assess a greater amount of credit than is otherwise allowed by reducing the exclusion amount, although this may not effect that intent. § 2011(e) provides that the credit under § 2011 shall not exceed the amount of tax imposed under § 2001, reduced by the amount of the unified credit under § 2010. Thus, by application of the reduced Illinois exclusion amount, it follows that the amount of credit calculated under the Illinois law would be limited to the federal exclusion amount by operation of the federal table.
7. For example, if the estate was $2.5 million in 2009, there would be no federal estate tax because the applicable exclusion amount would be $3.5 million. However, for Illinois purposes, the applicable exclusion would only be $2 million, thus $500,000 would be subject to tax. If the client wanted to forgo fully utilizing the federal exclusion amount in order to avoid Illinois estate tax, a second marital could be used to shield the amount subject to Illinois estate tax. This comes at a cost, however, because upon the second spouse's death more property is subject to federal estate tax which may come at a higher tax cost.
8. W.S.A. § 72.01(11m). Prior to this enactment, Wisconsin applied a "pick-up" tax system.
9. For a complete review of the status of each state's current law, see "A Survey of Post-EGTRRA State Estate Tax Regimes," by Paul E. Van Horn of McLaughlin & Stern, LLP which was presented to the ABA Section of Taxation, Estate and Gift Tax Committee on May 9th, 2003. The author was also a contributor to Mr. Van Horn's analysis.
10. Misouri's estate tax statute can be found under R.S.Mo. § 145.011 and acknowledges as of July 6, 2002 under R.S.Mo. § 145.1000 that if the federal estate tax is repealed, then no tax shall be imposed on the transfer of a decedent's estate in Missouri. Similarly, Michigan is not exactly a pure pick-up tax, but the law allows the personal representative to elect to adopt the law in effect on the decedent's death, thereby by applying the EGTRRA reductions in the state death tax credit and elimination of the credit in 2005. M.C.L. § 205.256(g).
11. Reference to the Indiana inheritance laws and the state death tax credit can be found under Ind.Code § 6-4.1-1-4; reference to the Iowa inheritance laws and the state death tax credit can be found under Iowa Code § 451.2, and reference to the Kentucky inheritance laws and the state death tax credit can be found under Ky. Rev. Stat. Ann. § 140.130.
How to tackle Hackl: Turning future gifts into present
interests
By James M. Lestikow, Hinshaw & Culbertson, Springfield
Introduction
The annual exclusion from federal gift tax has been in the Internal Revenue Code (IRC) since 1932, allowing relatively small gifts to go unreported. IRC §2503(b). Beginning in 2002, the limit became $11,000 per individual for an unlimited number of individual gifts. By using the gift splitting provision under IRC §2513, the taxpayer can effectively double the number of annual exclusion gifts with a cooperative spouse's consent. Gifts of stock or interests in closely held corporations, LLCs or partnerships have long been a favorite subject for gift giving. However, the United States Tax Court in Hackl v. Commissioner, 118 T.C. 279 (2002), held that to qualify as a present interest, as required for the annual gift tax exclusion, a gift must confer on the donee, not just vested rights, but a substantial economic benefit by reason of use, possession or enjoyment of either the property itself or income from the property. And under that standard, the gift of voting and non-voting interests in an Indiana LLC did not qualify for the annual gift tax exclusion. The case was appealed to the United States Court of Appeals for the 7th Circuit, and on July 11, 2003, the court handed down its decisions Nos. 02-3093 and 02-3094 affirming the Tax Court ruling.
Background
Albert J. Hackl and his wife Christine began a tree farming business after Mr. Hackl's retirement. He purchased two tree farms and contributed them ($4.5 million), as well as about $8 million in cash and securities to Treeco, LLC, and he and his wife initially owned all of the membership interests, which included both voting and nonvoting shares. A.J. Hackl served as the company's manager. Under the Operating Agreement, the manager served for life or until resignation, removal or incapacity, and had the power to appoint a successor. He also had the power to dissolve the company. In addition, the manager had the power to control any financial distributions and members needed his approval to withdraw from the company or sell shares. Any shares transferred without consent conveyed economic rights, but no membership or voting rights. After A.J. Hackl's tenure as manager, an 80 percent majority of the voting members could amend the Articles of Organization and dissolve the company.
To the date of the Tax Court decision, the company operated at a loss and had made no distributions to owners. The owners made annual transfers of voting and non-voting shares to their children, their children's spouses, and a trust set up for their grandchildren. The company was started in 1995, and by 1998, 51 percent of the company's voting shares were in the hands of parties other than A.J. and Christine Hackl. The Hackls treated the transfers as excludable gifts on gift tax returns. The IRS disagreed.
Argument
The Tax Court, and now the Circuit Court of Appeals for the Seventh District, said that it is not enough that the donor gives up all of their legal rights to the gifted property to make it a present interest gift. The applicable Treasury Regulations states that a "future interest" is a legal term that applies to interests "which are limited to commence in