June 2012

QUARTERLY INSIGHTS FOR CLIENTS: Opportunity To Make Tax-free Gifts Set To Expire

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This year we have a unique opportunity to avoid paying unnecessary future estate tax. Making gifts before the end of 2012 takes advantage of the opportunity. Unfortunately, tax and economic changes on the horizon make this a “use it or lose it” affair.

Temporary estate, gift and generation-skipping transfer (GST) tax reductions enacted in 2010 expire at the end of 2012. If Congress does not pass new legislation, there will be a dramatic tax increase on January 1, 2013. The 35% tax rate will return to 2001 levels of up to 55% (plus a 5% surcharge on large estates). The $5.12 million tax exemption will drop to $1 million (plus an inflation addition for the GST tax).

In addition to these changes in rates and exemptions, the administration’s 2013 budget proposals would end other tax benefits. If approved, the budget would eliminate beneficial short-term grantor retained annuity trusts (GRATs), tax-sheltered generation-skipping trusts beyond 90 years, valuation discounts for some family businesses and partnerships, and benefits from gifts or sales to “grantor trusts,” and would increase gift, estate, and GST taxes back to 2009 levels. Also worth noting is that low interest rates and depressed asset values have made some trusts more tax efficient in recent years. If rates and asset values are hitting bottom, these trusts may start losing their advantages.

For those who want to lock in future estate tax savings the message seems clear: this is the year to design and complete tax-saving gifts. The tax law now on the books will limit gift tax free gifts to just $1 million beginning next year. By acting this year, an individual may give up to $5.12 million without gift tax (up to $10.24 million for married couples). These gifts will save future estate tax on all growth and accumulated income on the asset given away. The savings can be large: if $3 million is given to family and it appreciates at an annual rate of 5%, growing to nearly $8 million in 20 years, the estate tax savings would be more than $2.7 million if the 55% top rate returns. Also, by giving through trusts, assets can be protected from any creditors and ex-spouses of family members, and can benefit descendants many generations in the future, free of estate and GST taxes.

Some of the best ways to take advantage of this opportunity include:

Give directly to family or family trusts. Giving assets directly to adult children or grandchildren, or to trusts for them, takes advantage of the large gift tax credit with a minimum of planning complexity. Of course if a trust is used, it must be designed to implement the donor’s wishes about how the gift is used in the future.

Give a vacation home to a Qualified Personal Residence Trust (QPRT). A QPRT is a way to preserve a vacation home (or primary residence) for family. A current gift, at a discounted value, is made to a trust, but the owner keeps using the home for a number of years. The residence goes to family at the end of the trust with no future gift tax. Depressed real estate values and this year’s large gift tax exemption can make QPRTs work quite well, even though low interest rates usually do not favor them.

Create a life insurance trust. A gift of cash to a life insurance trust can be used to buy insurance on the donor. Today’s large gift tax credit allows a large cash gift without tax, and the purchase of a large insurance policy. A substantial insurance payment for family can result when the insured dies, free of both income and estate tax. It can be used to pay estate tax, preserve a family’s business and real estate, or invest in a long term family trust portfolio. The initial gift can create “leverage” because the life insurance payment usually is many times greater than the insurance policy cost.

Forgive outstanding family loans. Individuals who made loans to family members might forgive them. The same applies to outstanding purchase money notes due from family trusts for assets purchased by the trusts. The outstanding principal and accrued interest forgiven would be a gift, but the large gift tax credit allows forgiveness of significant loans without gift tax. This can eliminate future estate complexities that can occur with loans due at death from family members or trusts. Note that forgiving a loan requires no cash outlay.

Create a long-term GST trust. Creating a GST trust that lasts over several generations can protect assets from future estate tax for as long as the trust lasts. One can even create a trust that lasts indefinitely: a “dynasty trust.” In addition, GST trusts can be created in states that have no state income tax on trust income. The combination of a large gift in 2012, protected by the gift tax credit, future trust income and capital gains free of state income tax, and the avoidance of estate and GST tax for generations can result in a substantial increase in trust assets over time, all for the benefit of children, grandchildren, and other future descendants.

Give to a GRAT. Since we know that GRATs are still effective this year, and since current low interest rates favor them, it is worth considering them while the opportunity lasts. GRATs carry out a future gift of the potential growth in an asset or investment to family or family trusts, while keeping the current value of the asset put in the GRAT. GRATs are often designed so that no gift tax credit is used, and can be effective in combination with other gifts that use the credit to avoid gift tax.

Give or sell to a “grantor” trust. These techniques save tax because the income tax on trust income is paid by the person creating the trust, effectively creating a tax-free family trust. Also, there is no income tax on the sale of a family business or other asset to a grantor trust. Grantor trusts often are created via an initial gift to the trust, and a promissory note is then used to purchase the family business or other asset from the trust. The future value of the trust can grow into a large multiple of the initial gift. This year’s large gift tax credit and the risk that the tax advantages of these trusts may be eliminated make this an ideal time to consider this technique.

Use a family partnership or LLC. Family limited partnerships and LLCs have been used to move family businesses and investments down the generations at a reduced gift and estate tax cost. The key lies in “discounting” the underlying asset value below its value were the asset not held in a family limited partnership or LLC. For example, with a 30% discount, the $5.12 million gift tax credit allows a gift of over $7.3 million in underlying assets without gift tax. With the administration proposing an end to valuation discounts, it may be time to consider gifts to existing partnerships or LLCs, or even creating a new entity.

Anyone thinking about one of these opportunities should start sooner rather than later. It takes time to ponder how much one can afford to give, what assets to transfer, which techniques to use, and whether to give outright or through a trust that controls how the gift is to be used. Discussing these variables with your attorney well before year-end makes it easier to carefully design a plan that will fit your family’s circumstances. Working through the choices and creating necessary legal documents often takes a month or more. Since the fate of these opportunities likely rests with the outcome of the November elections, some individuals are designing a plan and preparing documents, but waiting until after the elections to implement their plans.

This publication is for informational purposes only and is not intended to provide legal or tax advice, or to create an attorney-client relationship.

Pursuant to IRS Circular 230, unless expressly stated to the contrary, any tax advice is not intended and cannot be used to (i) avoid penalties under the Internal Revenue Code or (ii) promote, market or recommend any transaction or matter to another party.