We are writing to alert you to an opportunity to potentially save substantial estate taxes, but you must take action before the clock runs out. At the end of 2010, Congress and the President agreed upon a new estate and gift tax system providing significant, although temporary, planning opportunities and incentives to transfer wealth to heirs through the end of 2012. The most important change in the law is the ability to make lifetime gifts of up to $5,120,000 in 2012 without the imposition of gift or GST tax. Unless Congress takes action before years’ end, the exemption will revert to $1 million in 2013.
Given these developments, we believe it is important for you to review your existing estate plan with an eye toward possibly taking advantage of what may prove to be an once-in-a-lifetime opportunity. The increased exemptions, combined with low interest rates and current economic conditions, create a unique window of opportunity for the transfer of wealth to children and others at little or no gift tax cost. There may never be a better time to consider substantial lifetime gifts of assets to family members.
Though it may be counter-intuitive for individuals to consider giving away assets during these difficult economic times, it’s not hard to understand why giving undervalued assets to the next generation is better than giving overvalued assets. Because of today’s economic conditions, many assets currently have artificially depressed values. Gifts of such assets remove the assets’ true value from your estate at a substantially lower or no gift tax cost because of the assets’ current depressed value. Even without considering the many opportunities to leverage such gifts, a simple gift of cash or marketable securities provides the added benefit of shifting the appreciation on the transferred assets to the recipient, which then accrues outside of the taxpayer’s estate.
Somewhat less obvious is how low interest rates create estate planning opportunities. This can be explained with the simple example of a loan between family members. If a parent were to make an interest-free loan to a child, the IRS would characterize the foregone interest as a taxable gift from the parent to the child. In order to prevent the IRS from characterizing a portion of the loan as a gift, the parent must charge a certain minimum amount of interest on the loan.
This minimum interest, known as the Applicable Federal Rate, or AFR, is tied to the rate of return on US Treasuries and is determined by the IRS on a monthly basis. The AFR is currently at or near an all-time low. However the rates have begun to creep upward. The May 2012 short-term rate (applicable for demand loans and loans of three years or less) is .28% per annum, up from .25% from April 2012. The mid-term rate for May 2012 (for loans between three and nine years) is 1.30% per annum, up from 1.15% from April 2012. The long-term rate (for loans over nine years) for May 2012 is 2.89% per annum, up from 2.72 from April 2012.
This means that if a parent makes a nine-year loan to his child, the child need only earn a return exceeding 1.30% per year on the borrowed funds to make the loan a successful estate planning strategy. This strategy can also be successful if it allows the child to payoff other loans he has from third parties which are at interest rates above the AFR. The parent simply lends funds to the child, documented by a promissory note bearing interest at the AFR.
Using intra-family loans as an estate planning tool is based on the assumption that the child can earn a greater return on the loaned amounts than the AFR. When the values of assets are artificially depressed and the AFR is low, it is easier to assume that the cyclical market will rebound and that commercial interest rates will rise. In such an environment as exists today, an individual is more likely to earn a greater return on assets than the IRS’s relatively low assumed return.
The intra-family loan is the simplest and likely has the lowest transaction costs of the various wealth transfer techniques designed to take advantage of low interest rates. Other estate planning tools that are based on the likelihood of earning a greater return than that assumed by the IRS are grantor retained annuity trusts (GRAT), sales to “intentionally defective” grantor trusts (IDGT) and charitable lead annuity trusts (CLAT). From a probability of success perspective, there may never be a better time to consider the use of one or more of these strategies for transferring wealth at little or no gift tax cost.
A critical factor to consider when deciding whether or not now is the time to take action is the distinct possibility that these favorable transfer tax exemptions and rates may be repealed, in whole or in part, or otherwise negatively affected by future tax legislation. In addition to the scheduled expiration of these increased tax exemptions and lower rates, legislation is currently being considered by Congress which would adversely impact the use of short-term GRATs and sales to “intentionally defective” grantor trusts.
Although we can't control when we'll pay estate taxes, we can control when gifts are made. The $5,120,000 gift tax exemption is the largest that we have ever seen and, given the current fiscal constraints on Congress, may be an opportunity to transfer wealth that we may never see again when the law expires on December 31, 2012.