Update on estate planning – what should you gift now?

Estate planning remains stuck in limbo. That is, after 2012, the $5 million credit for gift and estate taxes goes away and we could be back at a $1 million credit. Also, the generation skipping tax limit now at $5 million would decrease. Finally, the portability of estate tax exemptions between spouses expires, meaning that the survivor can no longer use any credit amount not used by the first spouse, which would allow more to pass on estate tax free.
So far, Congress has taken no action. Many expect the 35% rate and a credit of at least $3 million to be the law for 2013 on. However, Congress failed to fix the estate tax for 2010 so nothing is certain.

Planning: This means you need to review your estate plan, especially your gifting strategies, and act now to take advantage of the higher gift tax credit. You can gift up to $5 million of assets free of gift tax now, or $10 million for married couples. The benefit is that all future income and appreciation on these gifts is removed from your estate. The downside is that the gifts are irrevocable, so you must be certain that what you pass on now you will not need later.
You always want to select assets that you expect will grow in value. If the assets decline, the strategy is frustrated. An example of what could go wrong is gift of a home at peak values that is now worth far less.

Remember that you have the annual gift tax exclusion allowing you and your spouse can each give $13,000 per year to any individual without eating away at your gift and estate tax credit. And note: any payments made to colleges or hospitals for the benefit of another person are not counted at all. (No gift tax return is required for these excluded amounts.)

How do you effectively structure the gift? Here are some examples:
• Family limited liability company (FLLC): With real estate or business assets, you can transfer minority interests in the FLLC to children or grandchildren. You retain control and the amount you gift is discounted because the minority interests lack control and lack marketability. You will need an appraisal for the value and the discount.
• Dynasty trust: This type of trust is designed to pass assets on multiple generations. Distributions can be made to the first generations, but they never actually receive a final amount – they rely on the trustee for any amounts to be distributed to them.
• Grantor retained annuity trust (GRAT): This trust transfers assets to children after a specified term while retaining a fixed annuity. The amount you gift is discounted, because children do not receive it until the end of the term. If the amount transfers, you succeed in transferring a discounted amount that becomes worth much more to the next generation.
• Qualified Personal Residence Trust (QPRT) Like the GRAT, your children receive your house in the future, so the value of the gift made now is discounted. You can even stay in the house after that term, but you have to pay rent, which is in effect another gift.

One note of caution: some have expressed the concern that if Congress does not act, the IRS could try to take back the excess in some fashion. Be sure to consult with your estate tax advisor before taking any moves.
We added gifting as a “to do” on the Finance Health Day page .

Estate Planning – Techniques for Reducing Taxes in Large Estates

The change in the tax law from the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 gives us a two year window for significant estate tax planning, ending December 31, 2012.

Instead of a $1 million lifetime cap, you can now gift up to $5 million. When your spouse joins in, a major amount of wealth can be transferred. This makes it important to act now, because the law could change in for 2013.

Leveraged Gifting – you can use a defective irrevocable trust (the defective grantor trust is discussed below) to fund an installment purchase of assets from you to the trust over time. The trust is “defective” so that there is no taxable transaction and no gain; it is as if you are selling to yourself. With the installment sale, a note is used and has to bear interest at the IRS mandated rates, the lowest rate of interest allowed. The goal is to repay the note using appreciated assets, where the transfer back to you is also not taxed, and complete the repayment before you die. If it is not completed, the note is an asset taxable in your estate.

Dynasty Trust – you can use the increased generation skipping transfer tax (GST) to pass more to grandchildren and future generations. Again, the new limits allow you to pass far more on to future generations.

Life Insurance Trust – an irrevocable trust that holds insurance for whatever purpose you design, while be excluded from your taxable estate. Your trustee would purchase insurance on your life. The risks of this alternative are that it is irrevocable and that the cost of the permanent insurance is very high.

Second-to-die Life Insurance – a trust that purchases second-to-die life insurance crates a source to pay estate taxes while not increasing the taxable estate.

GRAT – Another alternative is the grantor retained annuity trust (“GRAT”), which uses some portion of your unified credit as a window through which to pass assets at a discount created by the IRS tables that tell us what the asset gifted will be worth at the end of the term of the trust. You receive annuity payments during the term and the principal passes to your children at the end of the term. (This is why it must be funded with “excess” wealth – if you give the trust a term of 20 years but live many years thereafter, there will be many years during which you have foregone the benefit of the assets gifted). The expectation is that the principal will actually be worth more than the amount you gift to the trust, with such increased value escaping estate taxes. Under the new law, there are no GRAT or value limitations.

Cautions: First, the securities laws will treat you as the owner of trust assets for any restrictions on dealing with publicly traded stock. Second, if you die before the end of the term, assets revert to your estate and the structure collapses to look as if nothing was done. Last, a twist: if you stipulate that the trust will not terminate at your death, you substantially reduce the amount that gets thrown back to your estate, reducing the risk of not living through the term of the trust.

Tax inclusive and exclusive – the Sam Walton strategy can used when you want to transfer more than your unified credit alone will allow. If you make a taxable gift, it is tax exclusive (the tax comes from other assets). Thus, the tax is calculated as a percent of the gift. If you die owning the asset and it then passes to your children, it is tax inclusive as the tax is calculated as the total amount, so less of the assets pass to your children. QPRT – The qualified personal residence trust (“QPRT”) uses the unified credit and discount of a future value like the GRAT but applies it to your residence. Thus, both the benefits and risks are similar; it is the asset that differs.

“Defective” grantor trust – The “defective” grantor trust is effective for gift tax purposes and “defective” for income tax purposes so that assets are not included in your estate and yet you pay the tax on their appreciation. Paying the income taxes without any gift tax cost effectively gives away additional wealth. Again, you can leverage this with an installment sale.

Family Limited Partnership – the family limited partnership (“FLP”) is a partnership that you form, acting as the general partners and the limited partners. You transfer assets into the FLP such as any commercial real estate or your shares in your company. When this is complete, you can gift limited partnership interests to your children. Because only the general partners have any say in the management of the FLP, the IRS allows for a discount to the value of the limited partners interest. This discount is 35 to 40%, so more is passed to children without using up your unified credit. Unlike the other alternatives delineated below, when you transfer limited partner interests, your children receive the benefit now. In addition, you have the burden of tax returns for the FLP, as well as tax liability for children who may not receive distributions from the FLP to cover the taxes.

Charitable Remainder Trust – This charitable remainder trust (“CRT”) is a trust that pays a fixed annuity to you and then distributes the remaining principal to charities. You get a gift charitable deduction for the net present value of the future distribution to charities.

Charitable Lead Annuity Trust – This reverses the CRT, where a trust that pays a fixed annuity to charities selected by its trustees and then returns the remaining principal to you or to your estate. You get a gift tax deduction for the actuarial value of the annuity payments to charities or an estate tax charitable deduction.

Caution – you have an investment risk in each vehicle, where failing to generate the larger principal value in the future that you count on to use the strategy will frustrate its purposes. This is the risk of selecting assets that are expected to soar in value but instead collapse. Therefore, none of these alternatives should be considered until you are comfortable that you have “excess” wealth to pass to your children or to a charity and comfortable that you can make a commitment to do so that cannot be reversed. If you say “no” out of lack of comfort or confidence in any strategy, then you will want to stick to a basic plan for now.

What about the Future? Most observers expect the $5 million exemption to stay, along with the 35% estate tax rate. The exemption could be lower, or the rate increased. All of this is reason to review the ideas below and then update your estate plan.

Please see Estate Planning.

Estate tax update

As anticipated, Congress lifted the estate tax credit for 2011 from $1 million to $5 million, lowering the rate from 55% to 35%. Also, the date-of-death value again serves as the basis for estate assets. Also, the exemption is portable, viz. the un-used portion can be carried cover gifts by or the estate of the surviving spouse. Finally, the exemption will be indexed for inflation. (Estates can elect to use the 2010 rules for $1.3 million carry over basis for heirs).

There are some special rules: up to $1,020,000 of real property used for farming or business can get a discounted valuation; and when a closely held business comprises more than 35% of an estate, then as much as $476,000 of estate taxes can be deferred at a cost of 2% (charged by theirs).

In 2013, the exemption again falls back to $1 million and the rate goes back up to 55%, unless Congress again takes action.

For any 2010 estates, the retroactive action provides requires estates with a date-of-death valuation in excess of $1.3 million to file informational returns to report the carry over basis to the IRS and to heirs (as well as the $3 million for assets passing to a surviving spouse).

See more at Estate Planning.

(or contact us with your questions at Contact Us.)

Tax planning and 2011 estate tax law

While we await more details, recent action by Congress has the Bush tax cuts continuing for two more years, making the 2010 to 2011 tax planning straight forward – much like past years.

The new law provides relief on the AMT, no reduction in deductions and other benefits, which we plan to review in greater detail.

Also, it appears that, rather than return to a $1 million unified credit for estate taxes, at least a $3.5 million, if not a $5 million, credit and perhaps as low as a 35% tax rate will be the law next year.

Until we have more, please consider this summary of Tax planning: 2010 tips and traps, and 2011 changes

For 2010, some old provisions return and some new changes require action now:

2010 conversion to a Roth IRA has no income limit and two years to pay the taxes (please see to convert or not to convert).

Certain advantages in 2009 are lost for 2010 (see tax planning 2009 tips and traps and 2010 changes):
• AMT patch falls back;
• Casualty and theft loss limits fall back;
• Educator and tuition and fees deductions against adjusted gross income are not available;
• Deduction of state and local sales taxes ends;
• Exclusion of $2,400 of unemployment income ends; and
• Exclusion of income from qualified distributions from IRAs to charities ends.

However, some still apply in 2010:
• New home buyer credit (through the extended date)
• Energy Credit for solar power, fuel cells and certain energy efficient improvements are Schedule A deductions. There are two types of credit depending on what improvements were made to your home and taking the deductions requires you to have documentation.
• A tax refund can be used to buy U.S. Series I bonds.
• Note that a dependent child’s income is taxed when it exceeds $1,900.
• Educator’s Expense

Note that not all states accept the IRS changes, so the information and outcome could be different.

As we said before, tax planning involves a multi-year view to optimize what you end up paying.

You should also review your mortgage when you review tax information.

Estate Planning Update – still no federal estate tax

So far this year, there is no federal estate tax. This creates a planning quagmire.

Depending on how the estate tax clause is drafted in your estate plan, you could have the entire estate passing to children instead of a portion to the surviving spouse, or all of the estate passing to the surviving spouse, not using any state estate tax credit such that unnecessary state estate taxes become due at the first death.

Until Congress acts to pass a law to retroactively restore the federal estate tax, as expected, you should check your tax clause and review it with your attorney to see if a revision is in order.

You may find that your documents adequately deal with the combination of no federal estate tax and applicable state estate tax. Or, you may find that an amendment to your documents is needed to address this issue.

While reviewing the tax issue, make sure your durable powers of attorney and health care proxies or medial directives are also up to date.

Let us know if you have questions or comments. Thanks,

Steven