Scheduled Expiration of Gift and Estate Tax Provisions Creates Unique Window for Wealth Transfers

Changes to the federal gift, estate and generation-skipping transfer taxes – including the significantly increased exemptions and lower tax rates provided by the Tax Relief, Unemployment Insurance Authorization and Job Creation Act of 2010 – are scheduled to expire on December 31, 2012.

We urge you to review your planning this year and, to the extent possible, to act now to take advantage of what may turn out to be a transitory opportunity. Contact us with questions or for counsel. To learn more, click the links below.

How This Impacts the Remainder of 2012

Techniques and Factors to Consider

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How This Impacts the Remainder of 2012

For the remainder of 2012, the federal gift, estate and generation-skipping tax exemptions, which are indexed for inflation after 2011, equal $5.12 million per person ($10.24 million per couple), and the tax rate imposed on taxable transfers in excess of that amount will remain at an historically low 35 percent.

On January 1, 2013, in the absence of Congressional action, the exemption will fall to $1 million per person ($2 million per couple), and the tax rate on transfers in excess of that amount will increase to 55 percent.

The remainder of 2012 therefore presents a unique opportunity to transfer wealth to future generations via lifetime gifts and related sale transactions.

Techniques and Factors to Consider

To take advantage of the 2012 window, individuals with sizeable estates who can part with assets without adversely impacting their level of consumption should consider the following:

Outright Gifts. Gifts in excess of the currently available annual exclusion ($13,000 per donor, per donee) may be made to adult children and grandchildren (e.g., for the purpose of purchasing a residence or starting a business under current law), without incurring gift or generation-skipping tax, so long as the donors remain within the generous exemption amounts now available under TRA 2010. You may, of course, continue to make annual exclusion gifts either outright to your descendants, or to trusts for their benefit.

Use of Family Limited Partnership or Limited Liability Company to Make Gifts. To utilize larger amounts of your exemption in 2012, you may want to place an existing business with significant near and long term appreciation potential into either a family limited partnership (FLP) or limited liability company (LLC). Either of these entities would be useful for transferring a portion of your wealth at discounted values to your children during your life, either by gift or by sale.

Estate planning advantages of a family FLP/LLC include the ability to effect a wealth transfer to your children and, later, grandchildren, often at a significant tax discount – averaging between 30 percent and 40 percent – on account of lack of marketability and minority interest. Percentage portions of FLP/LLC interests easily can be transferred by gift to family members or to trusts for their benefit, and the gift tax that otherwise would be payable were the full value of the underlying property to be transferred, is significantly reduced. The value of any residual interest in the entity that you own at your death may also be discounted to reflect restrictions on transfer (lack of marketability) and, if you have reduced your interest below 50 percent through lifetime transfers, minority interest.

Dynasty Trust. Another option to consider involves the creation of an inter vivos (i.e., during lifetime), "generation-skipping" trust with the amount of your available generation-skipping transfer tax exemption (which, during 2012, is a combined total of $10.24 million per couple). The transfer of approximately $10 million in FLP/LLC interests to an inter vivos generation-skipping trust would permit you to secure the benefit of the growth on those assets for your descendants for a period of roughly 100 years (or longer, if created in a jurisdiction without a so-called "rule against perpetuities"). If properly structured, a dynasty trust’s assets should not be includable in the estate of a decedent who dies after 2012, even if the estate tax reverts back to pre-TRA 2010 levels.

While many people consider the ability to save estate tax over the lifetimes of several generations through the use of a dynasty trust to be of considerable advantage, you also may establish trusts for the benefit of your children or grandchildren that terminate at a specified age without the use of a dynasty trust. The creation of such a trust for a shorter term would still allow you to take advantage of the discounting techniques available for gifts of FLP/LLC interests, and would remove the value of the gifted property from your estate. In addition, virtually all trusts offer advantages in terms of creditor protection, asset management, and protection against possible divorce and remarriage of family members.

Grantor Trust. In either case, the trust (or trusts), whether or not it is generation-skipping, should be structured as a "grantor" trust. That is, so long as you are alive, you would be responsible for the payment of income taxes on the income earned by the trust. The payment of these taxes by you, instead of by the trust or its beneficiaries, in effect constitutes an additional tax-free gift to the beneficiaries, because it preserves trust corpus for their benefit. If the payment of these taxes becomes burdensome, however, the powers conferring grantor trust status may be relinquished, or the trust may, at the option of an independent trustee, pay its own taxes, thus eliminating your tax obligation.

Inter Vivos Credit Shelter Trust for Spouse and Descendants. One variation of the grantor trust described above is an irrevocable trust for the benefit of the grantor’s spouse and descendants using the grantor’s and (in appropriate circumstances) the grantor’s spouse’s $5.12 million lifetime gift tax exemption. This type of trust allows the grantor who may be reluctant or unable to part with significant assets to retain access to those assets through distributions of income and principal made to the grantor’s spouse for his or her health, education, maintenance and support. The spouse may, but need not, serve as the trustee of the trust for his or her benefit and may be granted a testamentary special power of appointment to direct the disposition of the assets upon his or her death.

Leveraging Your Gift: Sales of Assets to Grantor Trust. The status of the trust described in the preceding paragraph as a grantor trust also allows you to sell assets to the trust without realizing a gain on the sale and, because a properly structured sale is not a gift, without using your annual exclusions or lifetime gift tax exemptions. It therefore is currently possible for you to sell FLP/LLC interests (or other assets) to the trust - which should be funded (or "seeded") with an initial gift using all or part of your lifetime exemption - at their discounted value in exchange for an installment note that may be up to 10 times the size of the initial gift to the trust. The substitution of the note for the assets that are sold to the trust effectively "freezes" the value of those assets in your estate for estate tax purposes, while transferring all of the appreciation on the assets to future generations. The advantages of a sale to a grantor trust may be briefly summarized as follows:

No gain or loss is recognized on the sale to the trust.
No gift tax payments are due on the sale to the trust.
The grantor is not taxed separately on interest payments on the note.
The grantor continues to be taxed individually on all income generated by assets held by the trust, just as though it did not exist.
The grantor’s payment of taxes on the trust’s income does not constitute a gift for gift tax purposes in the absence of any unexercised right of reimbursement from the trust.
The assets sold to the trust, and, more importantly, the appreciation on those assets over time, are removed from the grantor’s estate.
The value of the note is includible in the grantor’s estate, but that value is fixed as of the date of the transfer, thus "freezing" the amount includible in the grantor’s estate.

The principal downside of a gift or nontaxable sale of assets to a grantor trust is that the assets do not receive a step-up in basis on the grantor’s death, as they would if they were includible in the grantor’s estate.

GRATs. A grantor-retained annuity trust, or "GRAT," is an example of a form of grantor trust that that has proven extremely effective in transferring appreciation on assets to one’s family members without the imposition of income or gift taxes. In a GRAT, the grantor transfers assets to a trust in exchange for an annuity that is retained for a term of years (which should be shorter than the grantor’s life expectancy), after which the assets pass to the remainder beneficiaries – usually the grantor’s children - either outright or in continuing trust. So long as the assets held by the GRAT appreciate at a rate in excess of the "test" rate prescribed by the IRS each month (currently 1.4 percent), and assuming that the grantor survives the initial term of the trust, wealth will be transferred to the remainder beneficiaries of the trust.

Fund Life Insurance Premium Payments. The ability of an insured to fund large life insurance purchases – particularly of single-premium policies – through gifts to an ILIT has just increased five-fold (keeping in mind the potential difficulties that may result from modified endowment contract considerations). Where gifts to ILITs used to be limited in large part to the grantor’s available "crummey" (i.e., annual exclusion), demand rights and his or her combined $2 million lifetime exemption (assuming a married grantor), ILITs can now be funded with up to $10 million per couple. The ability to make large gifts to ILITs is not just an advantage to the purchase of single-premium policies, however: the ability, in 2011 and 2012, to pre-fund an ILIT to pay for premiums that are due after 2012 (when it is possible that the gift tax exemption will revert to pre-TRA 2010 levels) will also be enhanced. This latter advantage should alleviate the concerns of many grantors/insureds who would otherwise be faced with complicated planning to fund such premiums over time.

Planning With Your Residence(s). One technique for reducing estate taxes ultimately payable on the value of a principal residence or vacation home, is the "Qualified Personal Residence Trust, " or "QPRT." Under this technique, you place your residence in an irrevocable trust for a fixed period of years (the term of the trust), during which you have the right to use and occupy the property. At the end of the trust term, the residence either passes outright to your descendants, as tenants in common, or is retained in trust for the benefit of your descendants.

At the creation of the trust, you are treated as having made a taxable gift equal to the discounted present value of the remainder interest in the residence, as determined by reference to IRS actuarial tables. The amount of this gift tax should be considerably less than the estate tax that would be imposed on the value of the residence should you die owning it, and may be sheltered by the use of your generous 2012 $10 million gift tax exemption.

Upon termination of the trust during your lifetime, no further transfer tax is imposed. In addition, any appreciation in the value of the residence is permanently removed from your estate, although at the cost of the loss of a basis step-up upon your death.

Clawback Drawback. As noted above, on January 1, 2013, the 2012 estate and gift tax exemption amounts of $5.12 million per person ($10.24 million per couple) are scheduled to revert to an exemption of $1 million per person ($2 million per couple). Commentators have noted that there is a possibility that gifts made during 2011 and 2012 may be added back to the base on which the estate tax is computed after 2012, thus potentially subjecting those tax-exempt 2011 and 2012 gifts to the estate tax. This possibility is referred to here as the "clawback" scenario.

It is clear that Congress did not intend this result, and we believe that, either as a matter of interpretation, regulation, or legislation, it will not occur. However, there are still good and sufficient reasons to proceed with gifts and/or sales in 2012, among them:

Donors who elected to make use of their enhanced gift and GST tax exemptions in 2011 and 2012 should be no worse off if clawback applies than those who died without having made gifts in those years. In either case, the gifts, whether made or foregone, will be included in the decedent’s estate and subject to tax at whatever rates and exemptions are then in effect.
There are significant benefits to using the $5 million per person ($10 million per couple) exemption in 2011 and 2012, including the fact that the appreciation on the gifted assets will not be subject to "clawback," even if the gifts themselves are. In addition, the ability to leverage gift transfers through sales of assets (e.g., to grantor trusts) or purchases of life insurance should enable donors to transfer the appreciation on assets far in excess of the nominal exemption amount.
There is always the possibility that the $5 million per person unified exemption will become permanent (or, in any event, subject to serial extensions), obviating the need to be concerned about clawback.

Clouds on the Horizon. We have already mentioned the imminent expiration – December 31, 2012 – of the increased exemptions and lower tax rates enacted as part of TRA 2010. Although no one can predict the future, it would appear that, even if the exemptions do not fall back all the way to $1 million per person ($2 million per couple), increasing revenue needs probably will militate towards higher transfer tax burdens in the future.

There are, moreover, a number of other reasons, set forth in the President’s proposed FY 2013 budget, to take advantage of the opportunities presented by the law as it stands in 2012. Most of these would take effect on January 1, 2013, if enacted (which, at this date, must be viewed as a relatively remote possibility):

Under the proposed budget, there would be a permanent extension of "freeze 2009" (i.e., the parameters in effect for calendar year 2009 – a top rate of 45 percent and an exemption amount of $3.5 million).
The budget also proposes to change the tax treatment of grantor trusts (making the assets of most such trusts includible in the estate of the grantor).
The budget would "federalize" the rule against perpetuities by reducing the generation-skipping tax exemption of most trusts to zero after 90 years. This proposal would significantly reduce the utility of dynasty trusts.
The currently "unified" gift, estate, and generation-skipping tax exemption would be "disunified," and the federal gift tax exemption would return to $1 million, thus making gifting during 2012 particularly attractive.
Valuation discounts for corporate and partnership assets would be restricted, making planning with closely-held entities more challenging.
For all of the foregoing reasons, we urge you to review your planning this year and, to the extent possible, to act now to take advantage of what may turn out to be a unique opportunity in 2012.

Contact Us

For more information or to schedule an appointment to review your estate plan, please contact a member of the Estates and Trusts Group of Buchanan Ingersoll & Rooney PC:

Deborah M. Beers :: 202 452 7919
Carol A. Kelley :: 202 452 7981
Elizabeth Carrott Minnigh :: 202 452 6048
David Margolis :: 412 562 8497