A limited opportunity for generous gift tax exclusions

The 2010 Tax Act is scheduled to expire on Dec. 31, 2012, at which time under current law the opportunities afforded under the 2010 Act will be lost. This article explores various tax planning opportunities created under the 2010 Act. Those hoping to make large gifts from their estates have a unique chance to do so tax-free during 2012. Through the remainder of this year, individuals can now gift as much as $5.12 million or $10.24 million per couple without paying any gift taxes. Under previous laws, the maximum lifetime gift tax exclusion capped out at $1 million for individuals and $2 million for couples. Gifting while these generous limits are in place may significantly lower an individual’s future estate tax liability.

Among the changes implemented through the 2010 Act, there were several substantive changes to gift, estate and generation-skipping transfer (GST) tax law, including the following:

(i) the estate, gift and GST tax rates were decreased from 45 percent in 2009 to 35 percent;

(ii) the estate and GST tax exemptions were increased from $3.5 million in 2009 to $5 million, indexed for inflation; and

(iii) the gift tax exemption was increased from $1 million in 2009 to $5 million, indexed for inflation.

If no legislation is enacted this year, then as of Jan. 1, 2013, pre-2001 law will return. There will be an estate and gift tax at graduated rates ranging from 37 percent to 55 percent (with a 5 percent surtax in certain cases), and there will be a $1 million gift and estate tax exemption. Even if new legislation is enacted by year-end, there is no guarantee that the currently available opportunities will remain intact. In fact, tax legislation has been proposed in the past two years that would not only reduce the estate tax exemption and increase tax rates, but would also limit the applicability of discounts for lack of control and marketability and diminish the benefits of certain tax planning strategies. Now is the time to take a meaningful look at the opportunities afforded under the tax law and determine whether it makes sense to take advantage of these opportunities for your clients before the window closes at the end of the year.

Direct Gifts

The increase of the gift tax exemption from $1 million to the current $5.12 million inclusive of inflation creates tremendous opportunities for clients to make direct gifts, either outright to designated beneficiaries or to trusts for their benefit. With economic conditions as they have been over the past few years, many assets are at historic lows in terms of value, which has the effect of leveraging any gifts that are made now. Not only will the gifted assets be outside of the donor’s taxable estate, but all appreciation and income attributable to the gifted assets will escape estate taxation.

For example, if you make a $5.12 million gift this year and die 20 years from now, the value of the gifted assets may grow to over $9 million assuming 3 percent annual growth. To the extent the recipients are in lower income tax brackets, the gifting program may produce income tax savings. In addition, the gifted assets will avoid New Jersey estate tax because there is no gift tax in New Jersey, and under most circumstances the New Jersey estate tax is computed on the basis of assets owned at death without taking gifts into account.

For married clients who are reluctant to lose the benefit of gifted assets, one spouse can make a gift to a trust for the benefit of the other spouse and children. If properly structured, a husband can make a gift to a trust for the benefit of his wife and children and the wife can gift assets to a similar but non-identical trust for the benefit of her husband and children. The trusts cannot be identical in form, as the IRS has held that if two individuals create identical trusts for each other, the trusts are disregarded for tax purposes. With sufficient differences in the two trusts, however, husband and wife can create trusts for each other so as to remove the gifted assets from both of their taxable estates while maintaining access to the trust assets if necessary. This creates substantial flexibility in the use of the gifted assets and the income generated by these assets.

Dynasty Trusts

While direct gifts can be made to children or trusts for their benefit, use of the applicable exclusion can be leveraged further if gifts are made to a dynasty trust for the benefit of children, grandchildren and even future generations. Although New Jersey does not permit a trust to last in perpetuity, multiple generations can benefit from assets transferred to a dynasty trust. The trust can provide for distributions to children for their health, education, maintenance and support, and at a deceased child’s death, the assets allocated to that child would pass to the child’s issue, again in lifetime trusts. Since the GST tax exemption is currently $5.12 million inclusive of inflation, this amount can be gifted to a dynasty trust and can pass from one generation to the next without any transfer taxes.

The lifetime trust structure utilized in a dynasty trust as assets pass from generation to generation has an additional advantage of protecting the assets from the claims of the beneficiaries’ creditors including a spouse in the event of a divorce. This structure also better ensures that assets remain in the bloodline. A child can become a co-trustee or sole trustee of his or her own trust at a responsible age, and while this may diminish some of the creditor protection planning, it permits the child to have greater access and control over the gifted assets. This is a very powerful approach that should be seriously considered given the enormous potential tax savings and the asset protection advantages.

Fractional Interest Transfers

One of the most powerful tax planning strategies involves the transfer of fractional interests in closely held businesses, real estate entities and investment partnerships. As an example, real estate owned by a limited liability company can be transferred through gifts of non-voting membership interests in the entity and the value of these gifts can be discounted to reflect the lack of control and lack of marketability inherent in the gifted interests. Discounts typically range from 20 percent to 35 percent depending on the assets owned by the entity and other factors. Assuming a 30 percent valuation discount, a nonvoting LLC interest with an underlying value of $7.31 million can be gifted to children or trusts for their benefit utilizing the $5.12 million applicable exclusion.

This approach can be used to leverage both the applicable exclusion amount and the GST exemption amount, thereby transferring more wealth than would otherwise be possible. It is possible, however, that the use of discounts will be restricted under new legislation so that this strategy should be seriously considered before year-end.

Life Insurance

Life insurance policies can be utilized to deliver significant wealth transfer tax savings. This may be even more appropriate under the 2010 Act. Clients can use a portion of the increased exemption by gifting cash to an irrevocable insurance trust, which then acquires life insurance that would then pass estate and GST tax-free. Given the uncertainty of future estate tax legislation, it may make sense to purchase insurance to create liquidity to pay potential estate taxes at death. Utilizing gifted assets to fund the purchase of insurance may be a good investment by the recipient and a powerful way to achieve significant estate and GST tax leveraging.

Other Gifts: GRATs, QPRTs, CLATs and More.

Other gifting structures exist. These are not new structures, but they have added appeal this year because of the generous gift tax exemption, the low gift tax rate, depressed property values, and historic low interest rates. For example, it is possible to create a grantor retained annuity trust (GRAT). A GRAT is an irrevocable trust to which the grantor transfers assets while retaining the right to receive an annuity in fixed or increasing dollar amounts for a period of years. The property remaining in the trust at the end of the period passes to other beneficiaries, for example the grantor’s children. The actuarial value of the annuity, because it is retained by the grantor, reduces the amount of the taxable gift. The only taxable gift is the gift of the remainder interest, which is calculated using applicable rates and discount factors published by the IRS every month. Because that calculation quantifies the present value of a future interest, there is an automatic discount in the value of the gift because it will not be realized by the remainder beneficiaries until a future date. The current low applicable interest rates used in the calculation depress the value of the remainder further for gift tax purposes. For illustration, a gift of $5,000,000 worth of property to a GRAT in April 2012 that pays $250,000 (5%) to the grantor every year for 20 years will result in a taxable gift of only $665,225 (the actuarial value of the remainder interest using April’s 1.4% applicable federal rate, assuming the grantor has not used any of his or her exemption prior to this gift). The grantor thus pays a gift tax of $232,829 ($665,225 x .35) to transfer $5,000,000 to his or her beneficiaries, while retaining a valuable annuity. If the grantor did not create this GRAT and passed away next year still owning the $5,000,000 in assets, the grantor’s estate would pay approximately $2,000,000 in estate tax on these assets alone, assuming no change in the estate tax laws between now and then. This is one of the key benefits of a GRAT.

A GRAT works best with income-producing assets that are expected to outperform the applicable federal rate over the term of the trust, and can be useful if the grantor wishes to make a significant gift but retain income from the property. If the grantor does not survive the trust term, all or a substantial portion of the value of the trust assets will be included in the grantor’s gross estate for estate tax purposes, which eradicates all or much of the tax savings feature of the GRAT. This risk can be eliminated if the grantor does not retain the right to the annuity, or minimized by setting a GRAT term that the grantor is reasonably expected to survive. By not retaining the right to the annuity, or by retaining the annuity but surviving the GRAT term, the value of the assets-including any appreciation after the date of the gift-will not be subject to estate tax in the grantor’s estate if the grantor survives the transfer by three years.

Other irrevocable trusts use the same general approach but with different assets or for different purposes. For example, a qualified personal residence trust (QPRT) can accomplish a similar result if a grantor wishes to retain the right to use a primary home or a vacation residence, but gift a remainder interest in the property to children or others at the end of the trust term, outright or in further trust. Today’s weak real estate values can provide further leverage for the gift of a residence, by depressing the value of the gift and placing future appreciation in the hands of the remainder beneficiaries, provided that the grantor survives the term of the QPRT.

For a grantor with philanthropic desires and no need for income from the gifted property, a charitable lead annuity trust (CLAT) can provide a favorite tax-exempt charitable organization with the right to an annuity for a period of years, with the remainder passing to the grantor’s children or others at the end of the trust term, outright or in further trust. Again, the taxable gift is the present value of the remainder interest at the time of the gift using the applicable federal rate. In this case the grantor will be entitled to a gift-tax charitable deduction for the present value of the annuity, and pay gift tax (or use gift tax exemption) only of the discounted value of the remainder interest.

The current low applicable federal rates also provide opportunities to employ installment sales as a companion to gifting techniques, to transfer further value to family members. For example, a single donor may wish to sell an investment property to his children. If the property is worth more than the amount of his available 2012 gift tax exemption (ignoring for this example discounts that may be available based on the nature of the property or the entity in which it is held), the balance could be sold to the children in equal shares in exchange for long-term notes payable to the grantor using the applicable federal rate for the month of the gift (taking into account discounts that would be available for the purchase of a non-controlling minority or fractional interest). For illustration, a 15-year note for $300,000 in April 2012 should use an applicable federal rate of at least 2.72%, resulting in annual interest payments of $8,160 owed by each child; notes with terms less than nine years would have a significantly lower rate: 1.15% in April 2012.

Another type of trust with favorable tax benefits in certain situations is an “intentionally defective grantor trust” (“IDGT”). This is an irrevocable trust which a grantor would establish for the benefit of others, e.g.children and grandchildren. Normally an irrevocable trust in which the grantor retains no beneficial interest would be its own taxpaying entity, and it or its beneficiaries would be subject to federal and state tax on its income and gains. In the IDGT, though, the grantor retains certain limited powers that require the income and gains of the trust to be reported by the grantor. The grantor pays the taxes associated with the trust for as long as he or she holds the powers, which allows the trust assets to grow in value without reduction for income taxes.

Donors might also consider using this year’s historic low applicable federal interest rates and large exemptions to gift interests in closely-held businesses or other assets to the next generation. These types of gifts are more complicated, often utilizing various types of trusts and business entities to consolidate the management of the closely-held business after the gifts are made. These structures can also include installment sales to IDGTs that are disregarded for income tax purposes. With careful planning and ongoing respect for the business structures that are employed, such gifts can represent very significant long-range gift and estate tax savings. Many of our wealthier clients are utilizing a variety of the planning mechanisms outlined in this article. Individuals who are considering these gifts should act soon and work with an experienced estate planning attorney, because these structures can take some months to put in place (depending on the assets being transferred) and will require the assistance of a qualified and experienced appraiser, who will need ample time to value the gifts at issue and prepare a thorough valuation report.

 Potential Risks

In considering and making gifts, there are several potential issues to consider. First, the recipient will have a basis in the gifted asset equal to the donor’s basis. This is generally less attractive than the “step-up” in basis, which provides the recipient of an inherited asset with a basis equal to date of death value. As an example, if an asset with a basis of $50,000 is gifted to a trust and is sold after the donor’s death for $100,000, the recipient will have to pay capital gains tax on the $50,000 difference between the $50,000 basis and the $100,000 sales price.

If instead that same asset had been inherited by the recipient, and the asset was valued at $90,000 at the decedent’s death, the capital gains tax would only be imposed on the $10,000 difference between the $90,000 stepped up basis and the $100,000 sales price. Therefore, to the extent possible, it makes sense to gift high basis assets.

Now is the time to address rare planning options for clients while the tax rates and exemptions are so favorable.