October 4, 2012

Update: The re-election of President Obama has strong implications in the estate planning area. As noted in this Client Alert sent in October, the current gift tax exemption is set to decrease and the estate and gift tax rate is set to increase when they both expire on December 31, 2012. Even though President Obama had indicated during his campaign that he is in favor of a gift tax exemption (the figure he used is less than the current exemption), it is unknown what future legislation will encompass. With such an uncertain future, we encourage you to again review this information, which highlights the benefits to you and your family of acting on today's rates.

As of 2011, changes to the estate tax laws took effect allowing unprecedented amounts of wealth to pass free of transfer taxation. Under the current Transfer Tax Exemption, $5,120,000 can be transferred free of gift and estate taxes. However, the law is scheduled to change dramatically at the end of 2012 unless Congress passes new legislation.

On January 1, 2013 and without Congressional action, the Transfer Tax Exemption will drop to $1,000,000 – and the current 35% estate and gift tax rate will increase to a 55% rate. Because the Republican and Democratic parties differ greatly on these matters, it is unlikely that Congress will take any action by the end of this year. With this in mind, there is a limited window of opportunity to utilize your Transfer Tax Exemption before it “sunsets” into history.

The ability to transfer up to $5,120,000 (or $10,240,000 for married couples) during lifetime without having to pay gift taxes provides unique opportunities to transfer wealth while saving significant transfer taxes. When combined with valuation discounts and leveraging strategies (which we discuss below), significant wealth can be preserved and passed along for many generations free of transfer taxes.

The simplest strategy to use the available Transfer Tax Exemption is to make lifetime gifts, which will almost always result in overall transfer tax savings – unless the gifted assets decline in value. Not only will lifetime gifts use the Transfer Tax Exemption (especially if the Transfer Tax Exemption is reduced) but lifetime gifts will also remove the appreciation (i.e., income and growth) on the assets transferred from the taxable estate.

Because the estate tax calculation is tied into the lifetime gifts made, there is uncertainty as to how the estate taxes will be calculated if the Transfer Tax Exemption is reduced in 2013. Even if there is a "claw back" (which would be the worst-case scenario), a donor would be in the same position as not having made the gift (but with the benefit of having the income and appreciation on the gifted property excluded from his or her taxable estate).

Structuring lifetime gifts

Consideration should be given to beneficial means of structuring any such gifts, the donor’s “comfort level” in making large gifts and the various options including:

It should be noted that currently every individual has a $5,120,000 GST Exemption that can be used for lifetime gift or testamentary transfers. Without further action by Congress, the GST Exemption is also scheduled to be reduced to $1,000,000 (as indexed for inflation) at the end of 2012.

Care must be taken in structuring a SLAT, particularly if both spouses are inclined to create a SLAT. If both spouses create a SLAT for the benefit of each other, the IRS could argue that they are “reciprocal trusts” and try to unwind them by asserting that neither spouse would have created his or her SLAT if the other spouse did not also create one. If the IRS is successful with such an argument, each spouse would be deemed to have created a SLAT for his or her own benefit, which would cause the trust assets to remain part of his or her taxable estate.

  • Outright vs. Trust. Although the gifts can simply be made outright, it is recommended that the gifts be made in dynasty gift trust structure. This will provide the donee(s) with a certain level of divorce, creditor and transfer tax protection that they could not provide for themselves.

  • Dynasty Gift Trusts. The advent of the current version of the generation-skipping transfer (GST) tax coupled with an increased desire to achieve creditor protection and revised state laws have drastically increased the use and popularity of long term – or perpetual – dynasty trusts. By retaining the property in a dynasty trust (and making it a spendthrift trust), the property will remain the separate property of the beneficiary (e.g., a child or other descendant) – and protected from attachment in a property settlement should there be a divorce or by a judgment creditor in a lawsuit. In addition, the trust assets and all appreciation would not be includible in the estates of any future generation of trust beneficiaries for estate tax purposes if the donor allocates his or her GST Exemption to the initial transfer.

  • Grantor Gift Trusts. Structuring a trust as a “grantor trust” allows the creator (i.e., the grantor) of the trust to pass additional funds free of gift and estate tax. Income tax laws require the grantor to report and pay the tax on the income earned by the trust – even though the income is paid to the trust. As the grantor's payment of the tax on the income earned by the trust is the grantor’s legal obligation, it is not considered an additional gift to the trust. As a result, the trust assets grow on an income tax free basis – with the grantor using his or her other assets to pay the income tax (further reducing the grantor’s estate for estate tax purposes).

  • Spousal Lifetime Access Trusts. Many individuals may not be comfortable giving away such large amounts of wealth. A “Spousal Lifetime Access Trust” (SLAT) may provide an acceptable middle ground. A SLAT is a trust to which a completed gift can be made, but provides for the donor's spouse as the beneficiary (or the donor's spouse and descendants as the beneficiaries).The SLAT’s assets can then be used for the benefit of the donor's spouse as provided in the trust. Upon the death of the donor's spouse, the SLAT assets would not be part of the estate of the donor's spouse for estate tax purposes and would pass to the named beneficiaries (i.e., the donor’s descendants) – even if the donor is then living. It is advisable to structure the SLAT as a "dynasty" trust .

Enhancing the gift structure

The above strategies are frequently enhanced through a selective determination of which assets should be the subject of the gift. Rather than transferring cash or stock in publicly-traded companies as the gift, additional wealth can be transferred by using leverage techniques. By specially structuring how your assets are held and which assets are transferred, there is essentially some influence over fair market values. The valuation of gifts of non-voting stock, limited partnership interests and membership interests in limited liability companies (LLC) generally entail minority interest and lack of marketability discounts, and the valuation of gifts of partial interests in real estate generally involve fractional interest discounts.

In addition, gifts may be further enhanced by using one or more advanced estate planning strategies such as a sale to an intentionally defective grantor trust (IDGT) or the creation of a grantor retained annuity trust (GRAT). While the specifics of such strategies are beyond the scope of this article, such techniques are typically part of a client's overall estate plan and are discussed in detail in the planning stages.

An uncertain future: How to best manage anticipated "sunset" of the current Transfer Tax Exemption

Unfortunately, the future of the gift, estate and GST tax laws are uncertain. If the Transfer Tax Exemption is reduced and the rates increase as anticipated under current law, many clients will benefit from utilizing the existing Transfer Tax Exemption before the end of 2012. We recommend that you speak to your Much Shelist attorney or contact a member of our Wealth Transfer & Succession Planning practice group to determine appropriate strategies that meet your objectives and address your circumstances.

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

This article contains material of general interest and should not be construed as legal advice or a legal opinion on any specific facts or circumstances. Under applicable rules of professional conduct, this content may be regarded as attorney advertising.