The Qualified Personal Residence Trust

Reducing the federal estate tax beyond basic estate planning (a Credit Shelter Trust) will require reducing the taxable estate. The easiest way to reduce the taxable estate is to gift assets to one’s ultimate beneficiaries. Gifting, though for this purpose, requires parting with dominion and control of the assets. Retaining almost any interest will cause the “gifted” assets to be included in the purported donor’s taxable estate. There are exceptions to this rule that one cannot retain access and control over gifted assets and not be taxed on such assets at death.

Properly structured, a “Qualified Personal Residence Trust” (QPRT) is one of these exceptions. To take advantage of this opportunity, the donor must irrevocably transfer a personal residence (primary or secondary) to a trustee for the benefit of named beneficiaries (for example, the donor’s children). The donor must select in the trust document a period of time for which the transferred property will be held in trust. While the property is held in trust, the donor has the exclusive right to occupy the property without paying any rent as well as the responsibility to pay (and deduct) real estate taxes and other operating expenses.

The selection of the period of time to retain access and control of the property is critical for a number of reasons. Once the selected period is up, the donor loses access and control and if the donor wishes to use the property, he or she can only do so with the consent of the beneficiaries and must pay the fair rental value of the property. Secondly, the tax benefits increase in proportion to the length of time selected, however the donor (or spouse in certain cases) must outlive the period selected or the value of the property will be includible in the donor’s estate.

A simple example can illustrate the above. Assume Mr. Donor aged 65 owns a vacation house with a current value of $1,000,000. He is certain that upon his demise, he would like his children to own this property. Assume further that he dies 9 years and 364 days from now when the property is worth $2,000,000. If he does nothing, of course the property and its $2, 000,000 value will be included in his taxable estate. Should he transfer the trust into a QPRT and select a 5 year term, the property will not be included in his taxable estate any value. The value of the gift (which would be taxed or would reduce his lifetime exemption) would be about $550,000(the value is discounted using the current section 7520, IRC rate for the selected period and also considering the donor’s life expectancy). For the first 5 years after the transfer, Mr. Donor has the exclusive right to use the property, but must pay the annual expenses of the property. After 5 years, he must pay his children fair market rent if he intends to continue to use the vacation home (and his children agree to rent it to him. Had he selected a 10 year term, the value of the gift would be discounted even further, but sine he did not outlive the selected period, the entire value of $2,000,000 is included in his taxable estate.

A potential downside to this technique is the loss of a stepped basis, but since the long term capital gain rate is considerably less than the federal estate and gift tax rate, this appears to be an acceptable trade-off. Also, while it is true that if the donor does not outlive the period selected to retain the property there is no estate tax savings, the “nothing ventured nothing gained” approach should apply. Finally, while the donor is required to pay rent after the selected retention period, some view thai as an opportunity to pass even more of one’s assets to his or her ultimate beneficiaries free of tax.

There are however many potential complications to such a transfer, especially concerning a sale of the property while it is held in trust. If this estate tax saving opportunity is of interest, you should contact an attorney conversant with these provisions to advise you and draft the appropriate document.

State of The Estate Tax

The federal estate tax exemption or the amount that is not subject to tax is $3,500,000 for an individual dying in 2009. The gift tax exemption is $1,000,000. The maximum federal estate and gift tax rate is 45%. Under current law there is no estate tax for individuals dying in 2010, but for 2011 and beyond the estate tax exemption will return to the pre 2000 amount of $1,000,000 per person. The gift tax exemption remains at $1,000,000 per person for 2010 and beyond. Beginning in 2011, the maximum federal estate and gift tax rate is 55%.

Most everyone believes that the current law will be changed before the year 2010 comes and there is no estate tax. The question is how the law will be changed and is there anything that can be done in 2009 to take advantage of certain provisions of the current law.

The “Certain Estate Tax Relief Act of 2009” (H.R.436) has already been introduced in the House. This bill would retain the current exemption of $3,500,000 indefinitely beginning in 2010. The rate of tax would remain at 45% (50% for large estates). This bill also contains other important provisions. On the positive side, the bill would repeal the carryover basis rules scheduled to become effective in 2010. One negative aspect of this legislation is the removal of the valuation discounts for transfers of non business assets to closely held entities such as Family Limited Partnerships.

Senate Democrats have recently offered their proposal which would set the exemption for both estate and gift tax purposes at $5,000,000 per person ($10,000,000 per couple) indexed for inflation. The estate and gift tax rate would be 35%. There are other proposed bills in Congress dealing with the estate tax. While the post 2009 estate tax law must be determined by our legislators, this may not happen this fall. It has been suggested that Congress may simply extend the law effective for 2009 to 2010 and deal with the broader issues later.

In the meantime, it may be wise to consider transferring non business assets to a Family Limited Partnership now. The discounts for lack of marketability and control are currently available, thus allowing a transferor to either pay less gift tax or transfer more property. While the final version of H.R. 436 could make the effective date retroactive, this seems unlikely since the current version has a prospective effective date.

Contesting A Will

It is not unusual to hear a disgruntled potential heir make a threat to challenge someone’s will. Such threats are easy to make, but usually unsuccessful. Feeling that one has not been treated fairly is not enough by itself to prevail in a will contest. A competent decedent has the right to leave their estate to anyone he or she chooses. A surviving spouse (and in some jurisdictions minor children) may under state law have the right to elect to take a higher percentage of the estate (usually 1/3) if greater than the percentage actually left to them, but this is not contesting the will.

Contesting a will is usually a lengthy and expensive endeavor and the contestant, assuming a sufficient connection or “standing”, also must have a valid legal basis to do so. The following reasons are generally accepted as the legal basis for challenging a will, although state law will vary as to the particulars.

The document offered for probate is not a legally enforceable will. Each state has its own formalities, but usually the will must either be in the decedent’s handwriting or witnessed by two adults and notarized. The document must also have been intended to be the decedent’s last will and not for example, a draft.

The decedent lacked the testamentary capacity to make a will. A person is deemed competent to make a will as long as they understand the composition of his or her estate and know the natural objects of their bounty regardless of any illness or other infirmity.

The decedent was unduly influenced by a person in a fiduciary relationship with the decedent who stands to gain from the will. If such a relationship is found to exist, the burden of proof often switches from the contestant to the proponent of the will (the executor).

Some or all of the will resulted from fraudulent representations or mistaken beliefs of the decedent. Fraud would result if the decedent were intentionally provided with false information. Innocent misrepresentations to or mistaken beliefs by the decedent though, would generally not invalidate a properly executed will.

It is usually advisable to consult an attorney when you think someone may challenge your will. The attorney can explain your state law to you in general and in particular the effect in your state of an “in terrorem” clause. Such a clause in your will attempts to limit challenges by providing that any challenger will be disinherited. Some states do not recognize such clauses as against public policy.

If you expect a will challenge you may also want to take such precautions as videotaping the signing of your will and where appropriate, obtaining documentation from a physician that in your doctor’s opinion, you are competent to make a last will and testament.